This is the accessible text file for GAO report number GAO-05-61
entitled 'Financial Regulation: Industry Changes Prompt Need to
Reconsider U.S. Regulatory Structure' which was released on November
08, 2004.
This text file was formatted by the U.S. Government Accountability
Office (GAO) to be accessible to users with visual impairments, as part
of a longer term project to improve GAO products' accessibility. Every
attempt has been made to maintain the structural and data integrity of
the original printed product. Accessibility features, such as text
descriptions of tables, consecutively numbered footnotes placed at the
end of the file, and the text of agency comment letters, are provided
but may not exactly duplicate the presentation or format of the printed
version. The portable document format (PDF) file is an exact electronic
replica of the printed version. We welcome your feedback. Please E-mail
your comments regarding the contents or accessibility features of this
document to Webmaster@gao.gov.
This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed
in its entirety without further permission from GAO. Because this work
may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this
material separately.
Report to the Chairman, Committee on Banking, Housing, and Urban
Affairs, U.S. Senate:
October 2004:
FINANCIAL REGULATION:
Industry Changes Prompt Need to Reconsider U.S. Regulatory Structure:
GAO-05-61:
GAO Highlights:
Highlights of GAO-05-61, a report to the Chairman, Committee on
Banking, Housing, and Urban Affairs, U.S. Senate:
Why GAO Did This Study:
In light of the passage of the 1999 Gramm-Leach-Bliley Act and
increased competition within the financial services industry at home
and abroad, GAO was asked to report on the current state of the U.S.
financial services regulatory structure. This report describes the
changes to the financial services industry, focusing on banking,
securities, futures, and insurance; the structure of the U.S. and other
regulatory systems; changes in regulatory and supervisory approaches;
efforts to foster communication and cooperation among U.S. and other
regulators; and the strengths and weaknesses of the current regulatory
structure.
What GAO Found:
The financial services industry has changed significantly over the last
several decades. Firms are now generally fewer and larger, provide more
and varied services, offer similar products, and operate in
increasingly global markets. These developments have both benefits and
risks, both for individual institutions and for the regulatory system
as a whole. Actions that are being taken to harmonize regulations
across countries, especially the Basel Accords and European Union
Financial Services Action Plan, are also affecting U.S. firms and
regulators. While the financial services industry and the international
regulatory framework have changed, the regulatory structure for
overseeing the U.S. financial services industry has not. Specialized
regulators still oversee separate functions—banking, securities,
futures, and insurance—and while some regulators do oversee complex
institutions at the holding company level, they generally rely on
functional regulators for information about the activities of
subsidiaries. In addition, no one agency or mechanism looks at risks
that cross markets or industry segments or at the system and its risks
as a whole.
Although a number of proposals for changing the U.S. regulatory system
have been put forth, the United States has chosen not to consolidate
its regulatory structure. At the same time, some industrial countries—
notably the United Kingdom—have consolidated their financial regulatory
structures, partly in response to industry changes. Absent fundamental
change in the overall regulatory structure, U.S. regulators have
initiated some changes in their regulatory approaches. For example,
starting with large, complex institutions, bank regulators, in the
1990s, sought to make their supervision more efficient and effective by
focusing on the areas of highest risk. And partly in response to
changes in European Union requirements, SEC has issued rules to provide
consolidated supervision of certain internationally active securities
firms on a voluntary basis. Regulators are also making efforts to
communicate in national and multinational forums, but efforts to
cooperate have not fully addressed the need to monitor risks across
markets, industry segments, and national borders. And from time to time
regulators engage in jurisdictional disputes that can distract them
from focusing on their primary missions.
GAO found that the U.S. regulatory structure worked well on some levels
but not on others. The strength and vitality of the U.S. financial
services industry demonstrate that the regulatory structure has not
failed. But some have questioned whether a fragmented regulatory system
is appropriate in today’s environment, particularly with large, complex
firms managing their risks on a consolidated basis. While the structure
of the agencies alone cannot ensure that regulators achieve their
goals—agencies also need the right people, tools, and policies and
procedures—it can hinder or facilitate their efforts to provide
consistent, comprehensive regulation that protects consumers and
enhances the delivery of financial services.
What GAO Recommends:
While GAO is not recommending a specific alternative regulatory
structure, Congress may wish to consider ways to improve the regulatory
structure for financial services, especially the oversight of complex,
internationally active firms. Options to consider include consolidating
within regulatory areas and creating an entity primarily to oversee
complex, internationally active firms, while leaving the rest of the
regulatory structure in place. Federal financial regulators provided
comments on these options.
www.gao.gov/cgi-bin/getrpt?GAO-05-61.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Thomas J. McCool at (202)
512-8678 or mccoolt@gao.gov.
[End of section]
Contents:
Letter:
Executive Summary:
Purpose:
Background:
Results in Brief:
GAO's Analysis:
Matter for Congressional Consideration:
Agency Comments and Our Evaluation:
Chapter 1: Introduction:
Traditionally, Financial Institutions Served as Intermediaries and
Transferred Some Risks:
The Financial Services Industry Faces Risks at the Institutional Level
and Systemwide:
U.S. Financial Services Regulation Has Multiple Goals:
U.S. Financial Regulatory System Includes a Variety of Regulatory
Bodies:
The United States Participates in International Organizations Dealing
with Regulatory Issues:
Objectives, Scope, and Methodology:
Chapter 2: The Financial Services Industry Has Undergone Dramatic
Changes:
Financial Services Have Played an Integral Part in Globalization:
Large Institutions Have Become Larger through Consolidation and
Conglomeration:
Roles of Large Financial Services Firms Have Changed and Financial
Products Have Converged, but Some Differences Remain:
As Financial Services Institutions Have Diversified, Introduced New
Products, and Become More Complex, Risks Have Changed:
Chapter 3: While Some Countries Have Consolidated Regulatory
Structures, the United States Has Chosen to Maintain Its Structure:
Some Countries and States Have Consolidated Their Regulatory
Structures:
United States Has Chosen to Maintain the Federal Regulatory Structure,
although Proposals Have Been Made to Change It:
Chapter 4: Regulators Are Adapting Regulatory and Supervisory
Approaches in Response to Industry Changes:
New Basel II Structure and EU Requirements Will Likely Affect Oversight
of U.S. Financial Institutions:
U.S. Regulators Have Made or Considered Some Other Changes to Their
Regulatory and Supervisory Approaches in Response to Industry Changes:
Chapter 5: Regulators Communicate and Coordinate in Multiple Ways, but
Concerns Remain:
U.S. Financial Regulators Communicate and Coordinate with Other
Regulators in Their Sectors, but Sometimes Find It Difficult to
Cooperate:
Financial Services Regulators Also Communicate across Financial
Sectors, but Do Not Effectively Identify Some Risks, Fraud, and Abuse
That Cross Sectors:
Chapter 6: The U.S. Regulatory System Has Strengths, but Its Structure
May Hinder Effective Regulation
U.S. Financial Services Regulatory System Has Generally Been Successful
but Lacks Overall Direction:
Structure of U.S. Financial Services Regulatory System May Not
Facilitate Oversight of Large, Complex Firms:
Structure of U.S. Financial Services Regulatory System May Not
Facilitate Response to Increased Globalization:
Regulators Provide Some Other Benefits by Specializing in Particular
Industry Segments or Geographic Units, but Specialization Has Costs As
Well:
Chapter 7: Congress May Want to Consider Changes to the U.S. Regulatory
Structure:
Matter for Congressional Consideration:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Comments from the Board of Governors of the Federal Reserve
System:
Appendix II: Comments from the Federal Deposit Insurance Corporation:
Appendix III: Comments from the Office of the Comptroller of the
Currency:
Appendix IV: Comments from the Office of Thrift Supervision:
Appendix V: Comments from the Securities and Exchange Commission:
Appendix VI: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Staff Acknowledgments:
Related GAO Products:
Table:
Table 1: Selected Retail Products by Financial Institution and
Function:
Figures:
Figure 1: Traditional Role of Financial Intermediaries:
Figure 2: International Debt Securities, 1987-2004:
Figure 3: Share of Assets in Each Sector Controlled by 10 Largest
Firms, 1996-2002:
Figure 4: Merger Activity among Banking Organizations, January 1990-
June 2004:
Figure 5: Number of Futures Contracts Traded, 1995-2003:
Figure 6: Structure of a Hypothetical Financial Holding Company:
Figure 7: The Three Pillars of Basel II:
Figure 8: United States--EU Regulatory Dialogue:
Figure 9: Regulators for a Hypothetical Financial Holding Company:
Abbreviations:
AFM: Netherlands Authority for the Financial Markets:
APRA: Australian Prudential Regulation Authority:
ASIC: Australian Securities and Investments Commission:
BaFin: German Federal Financial Supervisory Authority (Die
Bundesanstalt für Finanzdienstleistungsaufsicht):
CESR: Committee of European Securities Regulators:
CFMA: Commodity Futures Modernization Act:
CFTC: Commodity Futures Trading Commission:
CRS: Congressional Research Service:
CSE: consolidated supervised entity:
EU: European Union:
FBIIC: Financial and Banking Information Infrastructure Committee:
FCM: futures commission merchant:
FDIC: Federal Deposit Insurance Corporation:
FFIEC: Federal Financial Institutions Examination Council:
FSF: Financial Stability Forum:
GLBA: Gramm-Leach-Bliley Act:
IAIS: International Association of Insurance Supervisors:
ILC: industrial loan companies:
IMF: International Monetary Fund:
IOSCO: International Organization of Securities Commissions:
ISG: Intermarket Surveillance Group:
Japan-FSA: Financial Services Authority of Japan:
LTCM: Long-Term Capital Management:
NAIC: National Association of Insurance Commissioners:
NASDAQ: Nasdaq Stock Market Inc.
NCUA: National Credit Union Administration:
NFA: National Futures Association:
NYSE: New York Stock Exchange:
OCC: Office of the Comptroller of the Currency:
OTC: over the counter:
OTS: Office of Thrift Supervision:
SEC: Securities and Exchange Commission:
SIA: Securities Industry Association:
SIBHC: supervised investment bank holding company:
SRO: self-regulatory organization:
UK-FSA: Financial Services Authority of the United Kingdom:
Letter October 6, 2004:
The Honorable Richard C. Shelby:
Chairman:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
Dear Mr. Chairman:
This report responds to your request that we analyze the present
financial services regulatory structure. As you requested, this report
(1) describes the changes in the financial services industry over
recent decades, (2) describes changes that have occurred in the U.S.
regulatory structure and those of other industrialized countries, (3)
describes major changes in U.S. financial market regulation, (4)
discusses efforts to communicate, coordinate, and cooperate across
agencies in the present system, and (5) assesses the strengths and
weaknesses of the present financial regulatory structure. This report
includes a Matter for Congressional Consideration.
As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
from its issue date. We will then send copies to the Ranking Minority
Member of the Committee on Banking, Housing, and Urban Affairs; the
Chairman and Ranking Minority Member of the House Committee on
Financial Services; the Secretary of the Department of the Treasury;
the Chairman of the Board of Governors of the Federal Reserve System;
the Chairman of the Federal Deposit Insurance Corporation; the
Comptroller of the Currency; the Director of the Office of Thrift
Supervision; the Chairman of the Securities and Exchange Commission;
the Chairman of the Commodity Futures Trading Commission; the President
of the National Association of Insurance Commissioners; and other
interested parties. Copies will also be made available to others upon
request. In addition, this report will be available at no charge on the
GAO Web site at [Hyperlink, http://www.gao.gov].
This report was prepared under the direction of James M. McDermott,
Assistant Director. Please contact Mr. McDermott at (202) 512-5373 or
me at (202) 512-8678 if you or your staff have any questions about this
report. Major contributors to this report are listed in appendix VI.
Sincerely yours,
Signed by:
Thomas J. McCool:
Managing Director, Financial Markets and Community Investment:
[End of section]
Executive Summary:
Purpose:
It is 5 years since Congress passed the landmark Gramm-Leach-Bliley Act
(GLBA). In some ways, this act recognized the blurring of distinctions
among banking, securities, and insurance activities that had already
happened in the marketplace and codified regulatory decisions that had
been made to deal with these industry changes. While recognizing
industry and regulatory changes, that act changed neither the number of
regulatory agencies nor, in most cases, the primary objectives and
responsibilities of the existing agencies. The result of the blurring
of distinctions among the traditional financial services sectors,
recognized by GLBA, has enlarged the number and types of competitors
facing any firm, both domestically and internationally. Thus, what is
happening abroad from a regulatory perspective could impact the
competitive position of U.S. financial services institutions and the
ability of U.S. regulators to achieve their objectives. On this front,
many other industrialized countries are consolidating their financial
regulatory structures, and international forums are nearing completion
of important efforts to harmonize regulation across countries.
To better understand the effectiveness of the U.S. regulatory system in
this changing environment, the Chairman of the Committee on Banking,
Housing, and Urban Affairs requested an analysis of the present
regulatory structure. In particular, this report:
* describes the changes in the financial services industry over recent
decades;
* describes changes that have occurred in the U.S. regulatory structure
and those of other industrialized countries;
* describes major changes in U.S. financial market regulation;
* discusses efforts to communicate, coordinate, and cooperate across
agencies in the present system; and:
* assesses the strengths and weaknesses of the present financial
regulatory structure.
To meet these objectives GAO drew on its past work, reviewed other
relevant literature, conducted interviews with officials of federal and
state regulatory agencies, financial services industry
representatives, and other experts in the United States, the United
Kingdom, Belgium, and Germany and collected and analyzed data on
industry changes and regulatory activities. We conducted our work
between June 2003 and July 2004 in accordance with generally accepted
government auditing standards in Washington, D.C; Boston; Chicago; New
York City; Brussels, Belgium; London; and Berlin, Bonn, and Frankfurt,
Germany.
Background:
An efficient and effective financial services sector promotes economic
growth through the optimum allocation of financial capital. Achieving
that outcome rests primarily with the industry; however, in some cases
the market may not produce the most desirable outcomes and some form of
regulatory intervention is needed. In the United States, laws define
the roles and missions of the various regulators, which, to some
extent, are similar across the regulatory bodies. Regulators generally
have three objectives: (1) ensuring that institutions do not take on
excessive risk; (2) making sure that institutions conduct themselves in
ways that limit opportunities for fraud and abuse and provide consumers
and investors with accurate information and other protections that may
not be provided by the market; and (3) promoting financial stability by
limiting the opportunities for problems to spread from one institution
to another. However, laws and regulatory agency policies can set a
greater priority on some roles and missions than others. In addition,
the goals and objectives of the regulatory agencies have developed
somewhat differently over time, such that bank regulators generally
focus on the safety and soundness of banks, securities and futures
regulators focus on market integrity and investor protection, and
insurance regulators focus on the ability of insurance firms to meet
their commitments to the insured.
Generally, banking and securities activities are regulated at both the
state and federal levels, while futures are regulated primarily at the
federal level and insurance at the state level. For banking activities,
the Federal Reserve System (Federal Reserve)--including the Board of
Governors and the 12 Federal Reserve Banks--the Office of the
Comptroller of the Currency (OCC), the Office of Thrift Supervision
(OTS), the Federal Deposit Insurance Corporation (FDIC), and the
National Credit Union Administration (NCUA) are the primary federal
regulators. For securities activities, the Securities and Exchange
Commission (SEC) is the primary federal regulator, and for futures
products, the Commodity Futures Trading Commission (CFTC) is the
primary regulator. In addition, self-regulatory organizations under SEC
or CFTC jurisdiction provide oversight of securities and futures
dealers and exchanges. State regulators also provide oversight of
banking, securities, and insurance. For commercial and savings banks
with state bank charters, state banking departments charter the entity
and have supervisory responsibilities, while the Federal Reserve or
FDIC serve as the primary federal supervisor for these banks.[Footnote
1] For securities, states generally provide oversight to protect fraud
and abuse against within their jurisdictions. In contrast to these
products or activities, which are either regulated primarily at the
federal level or through a dual system of state and federal regulation,
insurance products are regulated primarily at the state level.
Organizationally, some regulatory agencies (OCC and OTS) are part of
the Department of the Treasury (Treasury), while the others are
independent entities or commissions. While OCC and OTS are part of
Treasury, their heads are appointed by the President and approved by
the Congress for fixed terms to ensure their independence.
The U.S. regulatory system for financial services is described as
"functional," so that financial products or activities are generally
regulated according to their function, no matter who offers the product
or participates in the activity. Broker-dealer activities, for
instance, are generally subject to SEC's jurisdiction, whether the
broker-dealer is a subsidiary of a bank holding company subject to
Federal Reserve supervision or a subsidiary of an investment bank. The
functional regulator approach is intended to provide consistency in
regulation and avoid the potential need for regulatory agencies to
develop expertise in all aspects of financial regulation.
Some firms engaged in the provision of banking, insurance, securities,
or futures products and activities in the United States are also
required by statute to be regulated at the holding company level. These
include bank holding and financial holding companies that are regulated
by the Federal Reserve, and thrift holding companies that are regulated
by OTS. In addition, SEC has statutory authority to oversee investment
bank holding companies, if they choose to be overseen in that way.
U.S. regulators conduct their activities within a broad array of
international forums and agencies. Some, such as the Basel Committee on
Banking Supervision (Basel Committee), International Organization of
Securities Commissions, and International Association of Insurance
Supervisors, are voluntary organizations of supervisors from a number
of countries. In addition, activities in the European Union--a treaty-
based organization of European countries in which those countries cede
some of their sovereignty so that decisions on specific matters of
joint interest can be made democratically at the European level--often
impact U.S. firms and regulators.
Results in Brief:
Over the last few decades, the environment in which the financial
services industry operates and the industry itself have undergone
dramatic changes that include globalization, consolidation within
traditional sectors, conglomeration across sectors, and convergence of
institutional roles and products. As a result of these changes, a
relatively small number of very large, diversified financial companies
now compete globally to meet a broad range of customer needs. Moreover,
the complexity of these firms and the products and services they offer
and use are changing the kinds and extent of risks in the financial
services industry. With regard to some risk, such as credit risk,
diversification across products, services, and markets might be
expected to reduce the risk faced by an individual institution.
However, it may not reduce the extent of risk in the system as a whole.
The increased sophistication in and interconnections throughout the
industry now make it difficult to determine the location and extent of
that risk. In addition, the difficulty of managing these large,
complex, globally active firms may expose them to greater operational
risk in that it is more difficult to impose adequate controls to
prevent fraud and abuse or some other operational problem at home or in
some small far-flung subsidiary. While there are fewer financial
services firms, the U.S. financial services industry retains a large
number of smaller entities that compete in more traditional segmented
markets, where they generally offer less complex or varied services
than the large, consolidated firms and compete more locally against
institutions in their sector.
For some time, the United States has chosen not to change its
regulatory structure substantially; however, since the mid-1990s,
several other industrialized countries and some U.S. states have
consolidated their regulatory structures, partially in response to
changes in the industry. Today, instead of an array of government
agencies and self-regulatory bodies, the countries GAO studied have one
or two supervisory agencies. Germany, Japan, and the United Kingdom
each have merged their regulatory structures into a single agency,
while Australia and the Netherlands have consolidated their regulatory
structures by assigning two of the major objectives of regulation--the
safety and soundness of institutions and conduct-of-business, which
includes market conduct, market integrity, and some aspects of
corporate governance--to different regulatory agencies. Within these
structures, the attainment of the third major regulatory objective,
financial stability, is shared with the central bank, which may also
share regulatory responsibilities. Those countries that have
consolidated their regulatory structures differ in some important
respects from the United States in that their economies and financial
sectors are smaller and generally less diverse. Several U.S. states
have similarly consolidated their regulatory agencies to better deal
with changes in the industry. Officials in the states GAO talked to
said that they are better able to meet the needs of consumers and to
cooperate across traditional industry lines; however, they report that
they have also sought to maintain the specialized knowledge regulators
brought from their respective agencies. Over the years, proposals have
also been made to consolidate various aspects of the U.S. regulatory
structure, but the United States has not chosen to adopt those changes
in any substantive way.
While the U.S. financial services regulatory structure has changed
little, regulators have modified their regulatory and supervisory
approaches to respond to market changes. For example, during the 1990s,
the bank regulatory agencies began risk-focused supervision of large,
complex banks, focusing supervisory attention on management policies
and procedures for areas believed to be the highest risk for the
banking organizations rather than trying to cover all aspects of bank
management; this risk-focused approach now applies to all banking
organizations. Somewhat earlier, the National Association of Insurance
Commissioners (NAIC) began to conduct groupwide financial analyses for
nationally significant insurance companies--companies that are large or
operate in several states. Some of the most pronounced changes in
regulatory approach have or are coming about as a result of efforts to
harmonize supervision across national boundaries. These efforts include
the Basel Committee negotiations to update capital requirements for
banks, generally referred to as Basel II,[Footnote 2] and the European
Union's Financial Services Action Plan, especially the Financial
Conglomerates Directive, which requires most large, complex firms doing
business in European Union countries to apply Basel capital standards
and become subject to consolidated supervision sometime in 2005. These
activities are leading to changes in the regulation and supervision of
some large or complex U.S. financial services firms that are active in
Europe. For example, SEC has, for the first time, adopted rules to
provide holding company oversight for certain large securities firms on
a voluntary basis. These rules incorporate some of the Basel II
framework for capital adequacy regulation.
Congress and the regulators themselves have recognized the need for
regulators in the U.S. system to communicate and coordinate activities
within and across the traditional financial services sectors. Several
formal and informal mechanisms exist to facilitate communication, both
within and across sectors, but problems remain. For example, at the
federal level, bank regulators coordinate examination and supervisory
policy, including many rule-making initiatives, through the Federal
Financial Institutions Examination Council and communicate
internationally through the Basel Committee. Officials serving in the
regional offices of the various federal bank regulators also reported
that they communicate formally and informally with each other and with
the state banking regulators in their region on a regular basis.
However, problems between OTS and FDIC and between OCC and FDIC
hindered a coordinated supervisory approach in bank failures in 2001
and 1999, respectively, and questions have arisen concerning the
efficacy of having several U.S. bank regulators present different
positions at Basel Committee negotiations. With regard to concerns
about Basel II, the regulators say that the process was necessarily
complex, they are required to air any disagreements through a
transparent, public process and, in the end, all of the provisions the
various U.S. bank regulators wanted were included in Basel II when it
was adopted in June 2004. Similarly, securities regulators at the state
and federal levels say they regularly coordinate enforcement actions,
but in certain high-profile cases, some disagreements have emerged
concerning the appropriateness and effectiveness of state and federal
actions. With regard to coordination across sectors, regulators have
taken some actions themselves, but have often been directed to
coordinate by Congress or the President, especially in response to
crises such as the stock market crash of 1987, the events of September
11, 2001, and recent corporate scandals. In a number of reports
evaluating these cross sector efforts, GAO has noted that no mechanism
exists for the monitoring of cross market or cross industry risks and
that information sharing has not been sufficient for identifying and
heading off potential crises. For example, in our report issued in 2000
on the President's Working Group, which includes the heads of the
Federal Reserve, Treasury, SEC, and CFTC, GAO reported that although
this group has served as a mechanism to share information during
unfolding crises, its activities generally have not included such
matters as routine surveillance of risks that cross markets or of
information sharing that is specific enough to help identify potential
crises.
Experts generally agree that the regulatory structure alone does not
determine whether regulatory objectives are achieved. Having an
adequate number of people with the right skills, clear objectives,
appropriate policies and procedures, and independence are probably more
important. However, the regulatory structure can often facilitate or
hinder the attainment of regulatory objectives. U.S. regulators and
financial market participants GAO spoke with generally emphasized that
the current regulatory structure has contributed to the development of
U.S. capital markets and overall economic growth and stability.
Industry participants also noted that regulators are generally of a
high quality. With the adoption of holding company supervision for a
broader segment of firms, some regulators may be better able to
understand and prepare for the risks that cut across functional areas
within a given holding company. In addition, in conjunction with agency
specific strategic planning activities, regulators may better monitor
risks that cut across the industry segments they oversee. However, no
agency or mechanism has the responsibility for monitoring risks that
cut more broadly across functional areas. Further, no agency has the
responsibility for analyzing the risks to the financial system as a
whole or planning strategically to address those risks and problems
that may develop in the future; there also is no mechanism for agencies
to cooperate effectively to perform these tasks. Some characteristics
of the U.S. regulatory structure--specialization of and competition
among the agencies--facilitate the attainment of some regulatory
objectives and hinder the attainment of others. On the positive side,
specialization allows regulators to better understand the risks
associated with particular activities or products and to better
represent the views of all segments of the industry. And competition
among regulators helps to account for regulatory innovation and
vigilance, by providing businesses with a method to move to regulators
whose approaches better match the businesses' operations. However,
these very characteristics may hinder the effective and efficient
oversight of large, complex, internationally active firms that compete
across sectors and national boundaries. In addition, the specialized
and differential oversight of holding companies in the different
sectors has the potential to create competitive imbalances among firms
in those sectors based on regulatory differences alone. Further,
competition among the regulators may limit the ability to negotiate
international agreements that would broadly be to the advantage of U.S.
firms. Similarly, some legal experts and regulators note that because
large, complex firms are managed centrally, regulators that specialize
in understanding risks specific to their "functional" sector may not
have the ability or authority to oversee the complex risks that span
financial sectors or the risk management methodologies employed by
these firms. Moreover, they note that competition among supervisory
authorities poses the risk that financial firms may well engage in a
form of regulatory arbitrage that involves the placement of particular
financial services or products in that part of the financial
conglomerate in which supervisory oversight is the least intrusive.
In this report, GAO recognizes that the specifics of a regulatory
structure may not be the critical determinant in whether a regulatory
system is successful because skilled regulators with the appropriate
policies and procedures could potentially overcome any impediments of
the structure through better communication and coordination across
agencies. However, because the structure may hinder the attainment of
certain regulatory goals, GAO suggests that Congress may want to
consider ways to consolidate the regulatory structure to (1) better
address the risks posed by large, complex firms and their consolidated
risk management approaches, (2) promote competition domestically and
internationally, and (3) contain systemic risk. Some of these ways may
require that the lines that now define regulatory responsibility change
to recognize the changed environment of financial services. This could
be done in several ways, including making relatively small changes such
as consolidating the bank regulators and, if Congress wishes to provide
an optional federal charter for insurance, creating a federal insurance
regulator, or making more dramatic changes such as creating a single
regulatory agency. Alternatively, a small agency could be created to
facilitate the oversight of all large, internationally active firms.
Each alternative has potential benefits and costs. For example,
consolidation could facilitate, but won't necessarily ensure, that
regulators communicate and coordinate, provide for regulatory
neutrality, and monitor risks across markets. However, larger
regulatory agencies could be less accountable to consumers or the
industry, possibly damaging the diversity that enriches our economy, or
could lose expertise critical to overseeing certain aspects of the
industry. In addition, change itself has certain costs, such as the
costs of rewriting the various laws that support the current regulatory
structure and any unintended consequences that could result during the
movement from the current structure to a new structure.
GAO's Analysis:
The Financial Services Industry Has Undergone Dramatic Changes:
The environment in which the financial services industry operates and
the industry itself have undergone dramatic changes. First,
globalization has become a predominant characteristic of modern
economic life and has affected and been affected by the financial
services sector. Capital moves across national boundaries, and many
financial services firms operate globally. For example, foreign firms
increasingly own U.S. life insurers and many U.S. banks and securities
firms are internationally active. In addition, Citigroup has a
significant retail banking business in Germany, while ING, a Dutch
firm, seeks to attract deposits in its U.S. thrift. Second,
consolidation of firms within the "functional" areas of banking,
securities, and insurance and conglomeration of firms across these
areas have increasingly come to characterize the large players in the
industry. Since 1995, 40 large banking organizations have merged or
acquired each other to such an extent that today just 6 very large
institutions remain. Similarly, the number of securities and futures
firms and the number of insurance companies have also declined while
generally the industry has grown. With regard to increased
conglomeration, a research report by International Monetary Fund staff-
-based on a worldwide sample of the largest 500 financial services
firms in terms of assets--shows that the percentage of U.S. financial
institutions in the sample that were engaged to some significant degree
in at least two of the functional sectors of banking, securities, and
insurance increased from 42 percent in 1995 to 61.5 percent in 2000,
and that these conglomerates held 73 percent of the assets of all of
the U.S. firms included in the sample. Commonly, large firms will seek
to use their size to meet a wider array of customer demand for
different financial products and services and to diversify an
individual firm's risk profile. Third, the roles of financial
institutions and the products and services they offer have converged,
so that many of these institutions are competing to offer similar
services to customers. While these changes are occurring, the U.S.
economy still has a large number of smaller entities that compete in
more traditional segmented markets, where they generally offer less
complex or varied services than the large, consolidated firms and
compete more locally against institutions in their sector.
As a result of changes in the industry, as well as the development of
complex financial products, the financial services industry has become
more complex, and thus the kinds and extent of risks the industry faces
are changing. It is generally agreed that banks can better withstand
defaults by segments of their creditors, because they now serve a range
of geographic markets and types of creditors. In addition, by
securitizing assets, certain institutions have generally been able to
reduce certain kinds of risks within an institution by passing them off
to other financial institutions or investors. However, the overall risk
to the industry may not have been reduced. Institutions that have
purchased securitized assets, for instance, may not have risk
management systems designed for the acquired risks. Further, the
relationships between institutions that securitize assets and those
buying these securitized assets range across regulatory and
governmental jurisdictions. Changes in the industry, especially the
growth of large institutions, have also affected the level and
management of operational and reputation risk. Large, complex firms
pose new risks for global financial stability because they can be
brought down by fraud and abuse or some other operational problem in
some small far-flung subsidiary. For example, the collapse of Barings,
a British bank with global operations, demonstrates the potential
vulnerability of firms to operational risk. In this case, management
did not effectively supervise a trader in Singapore, and his actions
brought down the whole bank.
While Some Countries Have Consolidated Regulatory Structures, the
United States Has Chosen to Maintain Its Structure:
Partly in response to industry changes, since the mid-1990s several
major industrial countries have consolidated their regulatory
structures. Germany, Japan, and the United Kingdom have each
consolidated their regulatory structures so that they rely primarily on
a single agency. The United Kingdom's move from nine regulatory bodies,
including self-regulatory organizations (SRO), to a single agency, the
Financial Services Authority (UK-FSA), is the most dramatic. UK-FSA
focuses strategically on achieving a small number of statutory
objectives--maintaining confidence in the financial system, promoting
public understanding of the financial system, securing the appropriate
degree of protection for consumers, and reducing the potential for
financial services firms to be used for a purpose connected with
financial crime--across a broad range of financial institutions and
activities. In pursuing these goals, UK-FSA is required to take account
of additional obligations, including achieving its goals in the most
efficient and effective way and not damaging the competitive position
of the United Kingdom internationally. To achieve its objectives under
these proscribed constraints, UK-FSA focuses on the largest firms and
on the needs of retail consumers. In addition, UK-FSA has taken actions
to break down the traditional industry silos and to ensure that large,
complex firms are overseen in consistent ways. While UK-FSA has sole
responsibility for the safety and soundness of financial institutions
and conduct-of-business, a tripartite group that includes the central
bank and Her Majesty's Treasury pursues the goal of financial
stability. The German single regulator, which is still quite new,
maintains the traditional silos of banking, securities, and insurance,
adding crosscutting groups to handle conglomerate supervision and
international issues. In addition, the new supervisory body shares some
supervisory responsibilities with Germany's central bank. Because of
persistent problems in the Japanese economy, especially in its banking
sector, the Japanese experiment with a single regulator illustrates the
point that a country's financial services regulatory structure alone is
not the determining factor in promoting economic growth through the
optimum allocation of financial capital.
GAO also reviewed documents for two other countries--Australia and the
Netherlands--that have consolidated their regulatory structures into
two agencies that have responsibility for a single regulatory
objective. In each country, one agency is responsible for prudential
regulation of all financial institutions and the other for ensuring
that financial firms and markets conduct their businesses properly.
These structures are based on the belief that government agencies
should have a single focus, so that one objective will not take
precedence over another. In the Netherlands, the Dutch central bank has
become the prudential regulator, while in Australia, the prudential
regulator is independent. In both cases, the central bank has the
primary responsibility for achieving the objective of financial
stability.
Some U.S. states have consolidated their structures in response to
industry changes as well. The states GAO spoke with had created a
single regulator structure, in part, because of the blurring of
traditional boundaries in the industry. These states said they are
better able to share information and cooperate across the sectors, but
that maintaining expertise in the traditional sectors is still
important. In addition, state officials said that while they did not
consolidate to reduce the cost of regulation, consolidation had reduced
costs.
The United States, which differs from the other countries that have
consolidated their structures in significant ways, such as having a
much larger and more diverse financial sector, has not consolidated its
regulatory structure. While GLBA substantially removed many of the
barriers that had previously separated commercial banking from
investment banking and insurance underwriting, GLBA did not
substantially change the U.S. regulatory structure. Over the years,
however, many proposals have been made to change the U.S. regulatory
structure, and these proposals continued to be made throughout the
1990s and early 2000s. These include proposals to consolidate the bank
regulators, merge SEC and CFTC, change the self-regulatory organization
structure for securities, and create a federal insurance regulator to
oversee those companies opting for the proposed federal insurance
charter. Proposals have also been made that cut across sectors,
including ones for a single federal regulator in each area, an
oversight board, and a fully consolidated regulator.
Regulators Are Adapting Regulatory and Supervisory Approaches in
Response to Industry Changes:
Partly as a response to efforts to harmonize regulation
internationally, regulators are adapting regulatory and supervisory
approaches to industry changes. The major international efforts include
the culmination of negotiations at the Basel Committee to update the
framework for capital adequacy requirements for banks and bank holding
companies, resulting in the Basel II framework, and European Union
implementation of the Financial Conglomerates Directive, which will
require most internationally active U.S. financial firms be subject to
consolidated supervision. U.S. regulators will be implementing the
Basel II requirements for large banking organizations over the next
several years. Basel II has three pillars: the first concerns setting
of minimum capital requirements, the second focuses on supervisory
review of and action in response to banks' capital adequacy, and the
third requires banks to publicly disclose information about their risk
profile, risk assessment processes, and the adequacy of their capital
levels to foster greater market discipline. The Financial Conglomerates
Directive requires that non-European financial conglomerates, certain
securities firms, and bank and financial holding companies operating in
the European Union have adequate consolidated supervision, which
includes application of Basel capital standards. Under the directive,
which is expected to go into effect in 2005, a non-European financial
conglomerate, securities firm, or bank or financial holding company
that is not considered to be supervised on a consolidated basis by an
equivalent home country supervisor would be subject to additional
supervision by regulators in European Union member states. As a result,
some major U.S. companies will need to demonstrate that they have
consolidated home country supervision. Some companies that own thrift
institutions may seek to meet these requirements by choosing OTS, which
has the authority to oversee thrift holding companies, as their home
country consolidated supervisor. For others, SEC has adopted rules for
voluntary oversight of certain holding companies with large broker-
dealers that are to be called Consolidated Supervised Entities. SEC is
pursuing some changes to the Basel II standards that would make those
requirements more relevant to securities activities undertaken by U.S.
firms.
U.S. regulators have adapted other regulatory and supervisory
approaches in response to industry changes. Beginning in the mid-1990s,
OCC and the Federal Reserve adopted new supervisory protocols for
large, complex institutions. Under this approach, examiners are
assigned full time to a bank (and are often on-site) so that they can
continually monitor and assess a banking organization's financial
condition and risk management systems through the review of a variety
of management reports and frequent meetings with key bank officials.
Examiners focus examinations on a bank's internal control and risk-
management systems; this risk-based approach is now used for banks of
all sizes. Securities regulators had repeatedly revised their
supervision protocols and had taken other actions to better understand
derivatives activities of securities firms. The Commodity Futures
Modernization Act of 2000--which had the primary goals of addressing
changes in market conditions, such as the introduction of a wider
variety of products--revamped many of the processes and goals of CFTC.
And, NAIC adopted risk-based capital requirements and began analyzing
significant insurance companies that do business in several states to
identify issues that could affect groups across state lines.
Regulators Communicate and Coordinate in Multiple Ways, but Concerns
Remain:
Most of the communication among U.S. regulators takes place within a
"functional" area. Within each of the four areas--banking, securities,
insurance, and futures--federal regulators have established
interagency groups to facilitate coordination and also communicate
informally on a variety of issues. Generally, within sectors, these
regulators communicate with each other, SROs, relevant state
regulators, and their international counterparts. In insurance, NAIC is
the primary vehicle for state regulators to communicate with each other
and to coordinate with insurance regulators abroad. While regulators
report frequent and regular meetings within their area, coordinated
responses are not always reached on some major issues.
Bank regulators coordinate examination and supervisory policy,
including many rule-making initiatives, through the Federal Financial
Institutions Examination Council and communicate internationally
through the Basel Committee. They also hold formal meetings at the
national and regional levels and communicate informally on a regular
basis.
Despite these practices, problems persist. In the 2001 failure of
Superior Bank, FSB, problems between OTS, the primary supervisor, and
FDIC hindered a coordinated supervisory approach, especially OTS's
refusal to let FDIC participate in examinations. The failure resulted
in a substantial loss to the deposit insurance fund. Similarly,
problems between OCC and FDIC were identified in the failure of the
First National Bank of Keystone (West Virginia), which failed in 1999.
(Regulators note that subsequent changes in policies should avoid
similar problems in the future.) On the international front, several
U.S. regulators joined the Basel II negotiations or presented their
views late in the process. Regulators said that this ensured that
concerns from all industry sectors were addressed in the negotiations,
that a transparent process was used, and that the United States
regulators obtained all of the provisions they wanted in the
international agreement, reached in June 2004. Critics complain that
having multiple regulators, particularly at the latest stages of
negotiations, needlessly complicated the process and could have
affected the outcome.
While SEC and state securities regulators told us that they coordinate
activities, including enforcement actions, some high-profile cases have
resulted in disagreements. SEC and state securities regulators have
brought several enforcement actions together; however, SEC and the
states have sometimes disagreed on what is an appropriate role for
each, and on how effective each has been. Similarly, in the insurance
area, where NAIC is a highly structured forum for communication, some
critics have noted that NAIC does not have the power to force state
regulators to adopt similar positions, while other critics have noted
that, as a quasigovernmental body, NAIC has too much power over state
insurance regulation.
Regulators themselves have identified the need to communicate across
sectors. For example, nine securities SROs created the Intermarket
Surveillance Group in 1983, and since then, futures SROs and foreign
exchanges have joined as affiliated members. The purpose of this group
is to coordinate and develop programs and procedures designed to assist
in identifying possible fraudulent and manipulative acts and practices
across markets and to share information. SEC and CFTC also jointly
developed regulations implementing portions of the Commodity Futures
Modernization Act, which lifted the ban on securities futures, but the
process was difficult. Prior to the passage of the act, staff of both
regulators had at times claimed sole jurisdiction over single stock
futures, necessitating development of a memorandum of understanding
that clarified joint oversight responsibilities for these instruments.
Congress and the President have often seen the need to direct
regulators to communicate across "functional" areas, sometimes in
response to crises. On a number of occasions, Congress has directed
regulators to communicate across "functional" areas. For example, in
GLBA, Congress directed regulators to communicate to better oversee the
risks of diversified holding companies; and following recent corporate
and accounting scandals, Congress directed them to collectively draft
guidance on complex structured finance transactions. Similarly, the
President has issued executive orders directing regulators to form the
President's Working Group and the Financial and Banking Information
Infrastructure Committee. The former was created to address issues
related to the 1987 stock market crash and was formally reactivated in
1994 to consider other issues, including the 1997 market decline and
threats to critical infrastructure. The latter was created after the
events of September 11, 2001, to coordinate federal and state financial
regulatory efforts to improve the reliability and security of the U.S.
financial system.
In evaluating these and other efforts of financial regulators to
communicate and coordinate, GAO has found that these ways do not allow
for a satisfactory assessment of risks that cross traditional
regulatory and industry boundaries and therefore may inhibit the
ability to detect and contain certain financial crises. In addition,
the existing ways regulators communicate and coordinate do not provide
for the systematic sharing of information on enforcement actions across
sectors, making it more difficult for regulators to identify potential
fraud and abuse, and for consumers to identify the relevant regulator.
The U.S. Regulatory System Has Strengths, but Its Structure May Hinder
Effective Regulation:
Financial markets exist to serve the needs of businesses, households,
and government, and financial regulation is judged, in part, by how
well markets meet the needs of these users. U.S. regulators and
financial market participants GAO spoke with generally emphasized that
the current regulatory structure has contributed to the development of
U.S. capital markets and overall growth and stability in the U.S.
economy. Industry participants also noted that regulators are generally
of a high quality. With the adoption of holding company supervision for
a broader segment of firms, some regulators may be better able to
understand and prepare for the risks that cut across functional areas
within a given holding company. In addition, in conjunction with agency
specific strategic planning activities, regulators may better monitor
risks that cut across the industry segments they oversee. However, no
agency or mechanism has the responsibility for monitoring risks that
cut more broadly across functional areas. Further, no agency has the
responsibility for analyzing the risks to the financial system as a
whole or planning strategically to address those risks and problems
that may develop in the future; there also is no mechanism for agencies
to cooperate effectively to perform these tasks. Agency structure alone
does not determine whether regulators do their jobs efficiently and
effectively, but it can facilitate or hinder achieving those goals.
Experts outside the regulatory system and some foreign regulators have
suggested that the U.S. regulatory system does not facilitate and may
hinder the efficient and effective oversight of large, complex,
internationally active firms. In particular, critics have noted that
"functional" regulation--focusing the oversight of different
regulators on specific activities within a financial services firm--is
inconsistent with these firms' centralized risk management. U.S. firms
and regulators are also likely to be affected by efforts to harmonize
regulation internationally. Large, internationally active firms say
these efforts are critical to providing financial services in a cost-
effective manner; however, the fragmented nature of the U.S. regulatory
system may hinder these negotiations. In addition, the increasing need
for a global perspective in the insurance industry where U.S. insurers
are increasingly foreign-owned is difficult within the state insurance
regulatory system.
While large U.S. firms compete across sectors, important differences
remain among banking, insurance, securities, and futures businesses. In
addition, many smaller firms operate only in a single sector or single
local market. As a result, the regulatory system benefits from the
specialized knowledge regulators acquire within their specialized
agencies. Regulatory agencies, however, may become "captives" of the
industries they are supposed to regulate and not be able to benefit
from economies of scale and scope related to the need for skills that
cut across regulatory agencies. In addition, the existence of
specialized agencies affords firms the opportunity to conduct
transactions in those parts of its organization with the least
intrusive regulation.
Congress May Want to Consider Changes to the U.S. Regulatory Structure:
The financial services industry is critical to the health and vitality
of the U.S. economy. While the industry itself bears primary
responsibility to effectively manage its risks, the importance of the
industry and the nature of those risks have created a need for
government regulation as well. While the specifics of a regulatory
structure, including the number of regulatory agencies and the roles
assigned to each, may not be the critical determinant in whether a
regulatory system is successful, the structure can facilitate or hinder
the attainment of regulatory goals. The skills of the people working in
the regulatory system, the clarity of its objectives, its independence,
and its management systems are critical to the success of financial
regulation.
Because our regulatory structure relies on having clear-cut boundaries
between the "functional" areas, industry changes that have caused those
boundaries to blur have placed strains on the regulatory framework.
While diversification across activities and locations may have lowered
the risks being faced by some large, complex, internationally active
firms, understanding and overseeing them have also become a much more
complex undertaking, requiring staff that can evaluate the risk
portfolio of these institutions and their management systems and
performance. Regulators must be able to ensure effective risk
management without needlessly restraining risk taking, which would
hinder economic growth. Similarly, because firms are taking on similar
risks across "functional" areas, to understand the risks of a given
institution or those that span institutions or industries, regulators
need a more complete picture of the risk portfolio of the financial
services industry both in the United States and abroad.
Recognizing that regulators could potentially overcome the impediments
of a fragmented regulatory structure through better communication and
coordination across agencies, Congress has created mechanisms for
coordination and on a number of specific issues has directed agencies
to coordinate their activities. In addition, GAO has repeatedly
recommended that federal regulators improve communication and
coordination. While GAO continues to support these recommendations, it
recognizes that the sheer number of regulatory bodies, their underlying
competitive nature, and differences in their regulatory philosophies
will continue to make the sharing of information difficult and true
coordination and cooperation in the most important or most visible
areas problematic as well. Therefore, Congress might want to consider
some changes to the U.S. financial services regulatory structure that
address weaknesses and potential vulnerabilities in our current system,
while maintaining its strengths.
Matter for Congressional Consideration:
While maintaining sector expertise and ensuring that financial
institutions comply with the law, Congress may want to consider some
consolidation or modification of the existing regulatory structure to
(1) better address the risks posed by large, complex, internationally
active firms and their consolidated risk management approaches; (2)
promote competition domestically and internationally; and (3) contain
systemic risk. If so, our work has identified several options that
Congress may wish to consider:
* consolidating the regulatory structure within the "functional" areas;
* moving to a regulatory structure based on a regulation by objective
or twin peaks model;
* combining all financial regulators into a single entity; or:
* creating or authorizing a single entity to oversee all large,
complex, internationally active firms, while leaving the rest of the
structure in place.
If Congress does wish to consider these or other options, it may want
to ensure that legislative goals are clearly set out for any changed
regulatory structure and that the agencies affected by any change are
given clear direction on the priorities that should be set for
achieving these goals. In addition, any change in the regulatory
structure would entail changing laws that currently govern financial
services oversight to conform to the new structure.
The first option would be to consolidate the regulatory structure
within "functional" areas--banking, securities, insurance, and
futures--so that at the federal level there would be a primary point of
contact for each. The two major changes to accomplish this at the
federal level would be consolidation of the bank regulators and, if
Congress wishes to provide a federal charter option for insurance, the
creation of an insurance regulatory entity. The bank regulatory
consolidation could be achieved within an existing banking agency or
with the creation of a new agency. In 1996, we recommended that the
number of federal agencies with primary responsibilities for bank
oversight be reduced. However, we noted that in the new structure, FDIC
should have the necessary authority to protect the deposit insurance
fund and that the Federal Reserve and Treasury should continue to be
involved in bank oversight, with access to supervisory information, so
that they could carry out their responsibilities for promoting
financial stability. We have not studied the issue of an optional
federal charter for insurers, but have through the years noted
difficulties with efforts to harmonize insurance regulation across
states through the NAIC-based structure. Having a primary federal
entity for each of the functional sectors would likely improve
communications and coordination across sectors because it would reduce
the number of entities that would need to be consulted on any issue.
Similarly, it would provide a central point of communication for issues
within a sector. Fewer bank regulators might reduce the cost of
regulation and the opportunities for regulatory arbitrage, choosing
charters so that transactions have the least amount of oversight. In
addition, issues related to the independence of a regulator from the
firms they oversee with a given kind of charter would be alleviated.
However, consolidating the banking regulators and establishing a
federal insurance regulator would raise concerns as well. While
improved communication and cooperation within sectors would help to
achieve the objectives outlined above, it would not directly address
many of them. In addition, some constituencies, such as thrifts, might
feel they were not getting proper attention for their concerns; and
opportunities for regulatory experimentation and the other positive
aspects of competition in banking could be reduced. Further, while this
option represents a more evolutionary change than some of the others,
it might still entail some costs associated with change, including
unintended consequences that would undoubtedly erupt as various banking
agencies and their staff jockeyed for position within the new banking
regulator. Similarly, the establishment of a federal insurance
regulator might have unintended consequences for state regulatory
bodies and for insurance firms as well.
Another option would be consolidating the regulatory structure using a
regulation by objective, or twin peaks model. The twin peaks model
would involve setting up one safety and soundness regulatory entity and
one conduct-of-business regulatory entity. The former would oversee
safety and soundness issues for insurers, banks, securities, and
futures activities, while the latter would ensure compliance with the
full range of conduct-of-business issues, including consumer and
investor protection, disclosure, money laundering, and some governance
issues. This could be accomplished by changing the tasks assigned to
existing agencies or by restructuring the agencies or creating new
ones. On the positive side, this option would directly address many of
the regulatory objectives related to larger, more complex institutions,
such as allowing for consolidated supervision, competitive neutrality,
understanding of the linkages within the safety and soundness and
conduct-of-business spheres, and regulatory independence. In addition,
conduct-of-business issues would not become subservient to safety and
soundness issues, as some fear. On the negative side, in addition to
the issues raised by any change in the structure, this structure would
not allow regulators to oversee the linkages between safety and
soundness and conduct-of-business. As reputational risk has become more
important, the linkages between these activities have become more
evident. In addition, if the controls and processes for conduct-of-
business issues and safety and soundness issues are coming from the top
of the organization, they are probably closely related. Finally,
combining regulators into multifunctional units might not allow the
regulatory system to maintain some of the advantages it now has,
including specialized expertise and the benefits of regulatory
competition and experimentation.
The most radical option would combine all financial regulators into a
single entity, similar to UK-FSA. The benefits of the single regulator
are that one body is accountable for all regulatory endeavors. It can
more easily evaluate the linkages within and across firms, including
those between conduct-of-business and safety and soundness
considerations, plan strategically across sectors, and facilitate the
allocation of resources to their highest priority use. However,
achieving these goals would depend on having the right people and
skills, clear regulatory objectives, effective tools, and appropriate
policies and procedures. While the UK-FSA model is intriguing, this
option raises some concerns for the United States. First, because of
the size of the U.S. economy and the number of financial institutions,
this entity would have to be very large and, thus, could be unwieldy
and costly. UK-FSA has about 2,300 employees, while estimates of the
number of regulators currently in the United States range from about
30,000 to 40,000. In addition, officials at UK-FSA have commented about
the difficulty of setting priorities when a large number of issues have
to be dealt with. Prioritizing these issues for the United States would
be particularly difficult. Further, an entity with this scope and size
might have difficulty responding to smaller players and might therefore
damage the diversity that has enriched the U.S. financial industry.
Also, staff at such an entity might lose or not develop the specialized
skills needed to understand both large and small companies and risks
that are specific to the different "functional" sectors. And, without
careful oversight, such a large and all-powerful entity might not be
accountable to consumers or the industry.
A more evolutionary change would be to have a single entity with
responsibility for the oversight of all large, complex, or
internationally active financial services firms that manage risk
centrally, compete with each other within and across sectors, and, by
their size and presence in a wide range of markets, pose systemic
risks. Having a single regulatory entity for large, complex, or
internationally active firms could be accomplished by giving this
responsibility to an existing regulator or by creating a new entity. A
new entity might consist of a small staff that would rely on the
expertise of staff at existing regulatory agencies to accomplish
supervisory tasks.
Having a single regulatory entity for large, complex, or
internationally active firms would have the advantage of addressing
industry changes, while leaving much of the U.S. regulatory structure
unchanged. A single regulatory entity for large, complex holding
companies would have responsibilities that more closely align with the
businesses' approach to risk than the current regulatory structure. In
addition, this entity could promote competition between these firms by
ensuring, to the greatest extent possible, that oversight is
competitively neutral. A single regulatory entity for internationally
active firms would also be better positioned to help coordinate the
views of the United States in international forums, so that the U.S.
firms are not competitively disadvantaged during negotiations. Finally,
this entity would be better able to appraise the linkages across large,
complex, internationally active firms and, thus, with the aid of the
Federal Reserve and Treasury, could contribute to promoting financial
stability. These potential improvements could be obtained without
losing the advantages afforded by our current specialized regulators,
who would continue to supervise the activities of regulated firms such
as broker-dealers or banks. However, this option also has drawbacks.
While the transition costs might be less than in some of the other
options, the creation of a new entity or changing the role of an
existing regulatory entity would still entail costs and likely some
unintended consequences. It might also be difficult to maintain the
appropriate balance between the interests of the large or
internationally active firms and smaller, more-specialized entities. It
also could involve creating one more regulatory agency in a system that
already has many agencies.
Agency Comments and Our Evaluation:
We received written comments on a draft of this report from the
Chairman of the Board of Governors of the Federal Reserve System, the
Chairman of FDIC, the Comptroller of the Currency, and the Director of
SEC's Division of Market Regulation. Their comments generally noted
that the U.S. financial regulatory system had balanced effective
regulation and market forces to promote a strong and innovative
financial system. Where appropriate, we have changed the report to
clarify this balance. In addition, the Chairman of the Federal Reserve
Board of Governors and the Chairman of FDIC stressed the importance of
the insured depository in the regulatory scheme. We provided a draft of
the report to Treasury, CFTC, and NAIC, for possible comments, but no
written comments were provided. All of the agencies provided technical
comments that were incorporated, where appropriate.
The Director of the Office of Thrift Supervision provided comments on a
draft of this report, saying that the report inadequately reflected
OTS's authority to supervise thrift holding companies and OTS's
international initiatives. While we have made some changes to the
report to clarify these topics, we believe that the report does
accurately discuss both topics. We also disagreed with the Director's
request that we delete references to the failure of Superior Bank, FSB,
which he thought did not reflect the causes of the failure or the
significant costs to the insurance funds from other failures. We did
change the report to make clear that this failure, and another
commercial bank failure in 1999, were caused by actions of the banks
themselves. However, these failures did highlight problems in
coordinating actions by the primary federal bank regulators and FDIC,
which also has authority to examine the banks it insures.
[End of section]
Chapter 1: Introduction:
The U.S. financial services industry has four sectors--banking,
securities, insurance, and futures,[Footnote 3] which together had 5.8
million employees and were responsible for almost one-tenth of the U.S.
gross domestic product in 2001. Traditionally, the financial services
industry promoted economic growth by intermediating between households,
businesses, and governments seeking to increase their assets through
savings and those interested in increasing their current spending
through borrowing. Intermediation differed in specific ways across the
major sectors. All financial services firms are exposed to a variety of
risks, including credit and market risk, and the industry as a whole is
exposed to systemic risk, which is generally defined as the risk that a
disruption (at a firm, in a market segment, to a settlement system,
etc.) could cause widespread difficulties at other firms, in other
market segments, or in the financial system as a whole.
The U.S. regulatory structure is composed of several agencies that tend
to specialize in given financial sectors and activities and has a
tradition of both state and federal regulation of some sectors and
activities. Generally, banking is regulated by several federal
regulators and by state bank regulators; securities by the Securities
and Exchange Commission (SEC), self-regulatory organizations (SROs),
and state regulators; futures by the Commodity Futures Trading
Commission (CFTC) and SROs; and insurance by state insurance
departments. Federal agencies are charged with overseeing particular
types of institutions and activities, and state agencies exercise a
similar function for entities that are not regulated exclusively by the
federal government. The federal agencies also operate within an
international framework that includes a variety of entities.
Traditionally, Financial Institutions Served as Intermediaries and
Transferred Some Risks:
Because those doing the saving in an economy and those doing the
spending have not always had direct access to each other, financial
services firms have traditionally served as intermediaries between
them. Figure 1 illustrates how financial services firms perform this
role. Different institutions--depositories, securities firms,
insurance companies, and futures firms--facilitated intermediation
differently, using different markets and products. In addition, some
firms helped households and businesses manage risk.
Figure 1: Traditional Role of Financial Intermediaries:
[See PDF for image]
[End of figure]
By most measures, depositories--commercial banks, thrifts,[Footnote 4]
credit unions,[Footnote 5] and industrial loan companies
(ILCs)[Footnote 6]--make up the largest group of financial
intermediaries. Traditionally, depositories used the funds they
received as deposits to make loans directly to businesses and
consumers, and various types of depositories were set up to serve
different constituents. Today, their activities are considerably more
diverse. For instance, banks and their affiliates are heavily involved
in the OTC derivatives market, in which transactions involving
financial derivatives are negotiated off exchanges. Depositories
include commercial banks, with about 73 percent of domestic deposits at
the end of 2003; thrifts, with about 14 percent of domestic deposits;
credit unions, with about 9 percent of domestic deposits; and ILCS,
with about 1 percent of domestic deposits. Although structural
differences remain, most powers and services of depositories have
converged over time, with few practical differences remaining in the
activities they undertake. Thus, in this report we will generally refer
to all depositories as banks.
Securities firms are second to banks in the amount of assets held and
revenue generated. Securities firms facilitate the transfer of funds
from savers to businesses or government through capital markets by
underwriting corporate equity securities (stocks) and corporate and
government debt securities (bonds). In addition, securities firms
facilitate the buying and selling of existing securities so that funds
move from all kinds of savers to all kinds of spenders. Several types
of securities firms participate in this process. Brokers are
intermediaries for those who buy and sell securities, and dealers are
those who buy and sell securities for their own accounts. Investment
banks underwrite new debt securities and equity securities and perform
broker-dealer functions. Investment banks buy the new issues and,
acting as wholesalers, sell them to institutional investors such as
banks, mutual funds, and pension funds. Investment companies, such as
mutual funds and hedge funds, gather funds from savers and collectively
pass them to spenders by purchasing assets in capital markets.
Investment advisers and transfer agents also play a role in this market
but do not act directly as intermediaries. By offering savings products
with varying risks and returns, securities firms also help savers
manage risk.
Insurance companies, the third largest sector of the financial services
industry, serve as intermediaries by taking the insurance premium
payments of households and businesses in payment for insurance coverage
and investing in corporate securities. The return on these investments
is expected to fund insurance companies' future liabilities. Insurance
premium payments come from the sale of products that usually fall into
three categories: property-casualty, life and health, and reinsurance.
Property-casualty insurance products cover business and household
assets such as cars, houses, business structures, inventories, and
goods in transit, as well as areas of liability such as product
performance and professional misconduct. Life insurance products
provide a tax-free sum to the beneficiary of the policyholder in the
event of the policyholder's death or other insured event. Health
insurance, which covers expenses associated with medical care and often
any financial losses individuals incur from injuries or illness, is not
directly relevant to this study. Insurance companies purchase
reinsurance, among other things, to spread risk and protect against
catastrophic events. Along with their role as financial intermediaries,
insurance companies have helped households and businesses manage risk
by allowing them to insure themselves against certain contingencies.
Agents who are employed by the insurance companies or work
independently generally distribute insurance products.
While firms that deal in exchange-traded futures (futures firms)
facilitate the transfer of funds, the primary role of futures markets
involves transferring risk and providing a mechanism for price
discovery. Market participants include hedgers, who are managing risks,
and speculators, who are taking a position on the direction of market
movement in hopes of making a profit. Futures contracts protect sellers
and purchasers of assets, such as physical commodities like pork
bellies or financial commodities like currencies, from changes in value
over time and provide opportunities for speculators to take varying
positions on the future value of these commodities in hopes of making a
profit. Several types of futures firms participate in this process.
Futures firms that execute orders and hold retail customer accounts are
futures commission merchants (FCMs). In addition, floor brokers make
trades for others and, along with floor traders, also make trades for
themselves. Commodity pool operators serve a function similar to that
of investment companies in securities markets in that they pool funds
for the purpose of trading futures contracts. Commodity trading
advisers and others also participate in futures markets.[Footnote 7]
The markets where exchange-traded futures contracts are traded are
generally called boards of trade.
The Financial Services Industry Faces Risks at the Institutional Level
and Systemwide:
To varying degrees, financial institutions are exposed to the following
types of risks:[Footnote 8]
Credit risk--the potential for financial losses resulting from the
failure of a borrower or counterparty to perform on an obligation.
Market risk--the potential for financial losses due to the increase or
decrease in the value or price of an asset or liability resulting from
broad movements in prices, such as interest rates, commodity prices,
stock prices, or the relative value of currencies (foreign exchange).
Liquidity risk--the potential for financial losses due to the inability
of a firm to meet its obligations because of an inability to liquidate
assets or obtain adequate funding, such as might occur if most
depositors or other creditors were to withdraw their funds from a firm.
Operational risk--the potential for unexpected financial losses due to
inadequate information systems, operational problems, and breaches in
internal controls, or fraud. These can include risks associated with
clearing and settling transactions, either as a principal or as an
agent, as well as risks associated with custodial functions (e.g.,
holding securities on behalf of others).
Reputational risk--the potential for financial losses that could result
from negative publicity regarding an institution's business practices
and subsequent decline in customers, costly litigation, or revenue
reductions.
Legal risk--the potential for financial losses due to breaches of law
or regulation that may result in heavy penalties or other costs.
Business/event risk--the potential for financial losses due to events
not covered above, such as credit rating downgrades (which affect a
firm's access to funding), or factors beyond the control of the firm,
such as major shocks in the firm's markets.
Insurance/actuarial risk--the risk of financial losses that an
insurance underwriter takes on in exchange for premiums, such as the
risk of premature death.
In addition to these risks, the financial system as a whole may be
vulnerable to systemic risk, which is generally defined as the risk
that a disruption (at a firm, in a market segment, to a settlement
system, etc.) could cause widespread difficulties at other firms, in
other market segments, or in the financial system as a whole. The
difficulties may be real in that institutions, markets, or settlement
systems are linked by transactions or may result in customers panicking
as a result of believing that failure at a given institution will
affect similar institutions and taking actions such as removing
deposits that precipitate systemic crises.
U.S. Financial Services Regulation Has Multiple Goals:
Generally, the United States relies on markets to promote the efficient
allocation of capital throughout the economy so as to best fund the
activities of households, business, and government. Financial services
are subject to oversight for several reasons that relate to the
inability of the market to ensure that the efficient allocation of
capital will take place. Essentially, markets cannot ensure that
certain kinds of misconduct, including fraud and abuse or market
manipulation, will not occur and that consumers/investors will have
adequate information to discipline institutions with regard to the
amount of risk they take on. In addition, because of systemic linkages,
the system as a whole may be prone to instability. While financial
services firms are aware of systemic risk, they will not likely take
steps to minimize it.
In the United States, laws define the roles and missions of the various
regulators, and to some extent these are similar across the regulatory
bodies. However, laws and regulatory agency policies can set a greater
priority on some roles and missions than others. In addition, the goals
and objectives of the regulatory agencies have developed somewhat
differently over time, such that bank regulators generally focus on the
safety and soundness of banks, securities and futures regulators focus
on market integrity and investor protection, and insurance regulators
focus on the ability of insurance firms to meet their commitments to
the insured.
In general, regulators help protect consumers/investors who may not
have the information or expertise necessary to protect themselves from
fraud and other deceptive practices, such as predatory lending or
insider trading, and that the marketplace may not necessarily provide.
Through monitoring activities, examinations, and inspections,
regulators oversee the conduct of institutions in an effort to ensure
that they do not engage in fraudulent activity and do provide
consumers/investors with the information they need to make appropriate
decisions and ultimately discipline the behavior of financial
institutions in the marketplace. However, in some areas providing
information through disclosure and assuring compliance with laws are
still not adequate to allow consumers/investors to influence firm
behavior. In these cases, regulators oversee how risk is managed and
seek to restrain excessive risk taking in order to promote the safety
and soundness of institutions that engage in certain kinds of
activities. In addition, by providing deposit insurance, overseeing
other insurance or guarantee funds, or directly intervening in the
marketplace, regulators take actions to ensure that the types of
widespread financial instability that could seriously disrupt economic
activity do not occur. However, with insurance or guarantee funds or
the expectation that some firms are too big to fail, the normal
disciplining of the market is disrupted, creating the "moral hazard"
that institutions will take on more risk than they would in the absence
of such insurance or expectations. As a result, the need for safety and
soundness oversight is intensified.
U.S. Financial Regulatory System Includes a Variety of Regulatory
Bodies:
The objectives of U.S. financial services regulation are pursued by a
complex combination of federal and state government agencies and self-
regulatory organizations (SROs). Generally, regulators specialize in
the oversight of financial entities in the various financial services
sectors. This specialization stems largely from the laws that
established these agencies and defined their missions. In addition,
some regulators have responsibilities to regulate holding companies
with subsidiaries that engage in various financial services activities.
The Federal Reserve[Footnote 9] and the Department of the Treasury
(Treasury) play a special role in maintaining financial stability.
Regulators Specialize in the Oversight of Financial Entities in Various
Sectors:
Five federal agencies oversee banks, including those chartered and
overseen by state regulatory agencies. The specific regulatory
configuration depends on the type of charter the banking institution
chooses. Banks may be regulated by the federal government alone, if
they are chartered by a federal regulator such as the Office of the
Comptroller of the Currency (OCC) or Office of Thrift Supervision
(OTS), or by both federal and state governments, if they are state-
chartered institutions. Securities and futures firms are regulated at
the federal level by the Securities and Exchange Commission (SEC) and
Commodity Futures Trading Commission (CFTC), respectively, which, in
turn, rely on SROs to assist with their oversight. State regulators
also have oversight and enforcement responsibilities for securities.
Insurance entities are overseen largely at the state level. There are
also regulators for government sponsored enterprises and pension funds,
which lie outside the scope of this report.
Multiple Regulators Oversee Banking Entities:
Banking institutions can generally determine their regulators by
choosing a particular kind of charter--commercial bank, thrift, credit
union, or industrial loan company. These charters may be obtained at
the state level or the national level for all except industrial loan
companies, which are chartered only at the state level. State
regulators charter institutions and participate in the oversight of
those institutions; however, all of these institutions have a primary
federal regulator if they have federal deposit insurance. State-
chartered commercial banks that are members of the Federal Reserve are
subject to supervision by that institution. Other state-chartered
banks, such as nonmember state banks, state savings banks, and ILCs,
with federally insured deposits are subject to Federal Deposit
Insurance Corporation (FDIC) oversight, while OTS supervises state-
chartered savings associations that are members of the Savings
Association Insurance Fund. Federally chartered institutions are
subject to oversight by their chartering agencies. OCC supervises
national banks, OTS supervises federally chartered thrifts, and the
National Credit Union Administration (NCUA) supervises federally
chartered credit unions. To the extent that OTC derivatives activities
take place in these institutions, they are subject to oversight by the
appropriate regulator. In addition, FDIC has backup supervisory
authority for those banks that are members of the insurance funds it
oversees and have a different primary supervisor.
The primary objectives of federal bank regulators include ensuring the
safe and sound practices and operations of the institutions they
oversee and the stability of financial markets. To achieve these goals,
regulators establish capital requirements, conduct on-site
examinations and off-site monitoring to assess a bank's financial
condition, and monitor compliance with banking laws. Regulators also
issue regulations, take enforcement actions, and close banks they
determine to be insolvent. In addition, federal regulators oversee and
take enforcement actions to ensure compliance with many consumer
protection laws such as those requiring fair access to banking services
and privacy protection.
The current bank regulatory structure evolved over time. OCC was
created by the National Currency Act of 1863, which was rewritten as
the National Bank Act of 1864. The Federal Reserve Act of 1913 created
the Federal Reserve, partly in response to the financial panic of 1907.
FDIC was established under the Banking Act of 1933. In 1933, Congress
also authorized the federal chartering of savings and loans by the
Federal Home Loan Bank Board, and, in 1934, the National Housing Act
established the Federal Savings and Loan Insurance Corporation to
provide for federal regulation of federally insured, state-chartered
thrifts. In 1989, OTS replaced the Federal Home Loan Bank Board as the
federal thrift institution regulator.[Footnote 10] Organizationally,
OCC and OTS are within the Department of the Treasury; however, the
Comptroller of the Currency and the Director of OTS are appointed by
the President and confirmed by the Senate for fixed terms, an
arrangement intended to help ensure the independence of these agencies.
The Federal Reserve's Board of Governors and FDIC are independent
federal agencies; the Comptroller of the Currency and Director of OTS
sit on FDIC's five-person board of directors. The three other board
members are appointed by the President for fixed terms with one
appointed as Chairman and another as Vice Chairman. As with the
Comptroller of the Currency and the Director of OTS, the Federal
Reserve's Board of Governors are appointed by the President and
confirmed by the Senate for fixed terms.
SROs Contribute to Security and Futures Regulation:
The Securities Exchange Act of 1934 established the regulatory
structure of U.S. securities markets. These markets are regulated under
a combination of self-regulation (subject to SEC oversight) and direct
SEC regulation. This regulatory structure was intended to give SROs
responsibility for administering their own operations, including most
of the daily oversight of the securities markets and their
participants. One of the SROs--NASD--is a national securities
association that regulates registered securities broker-
dealers.[Footnote 11] Other SROs include national securities exchanges
that operate the markets where securities are traded.[Footnote 12]
These SROs are primarily responsible for establishing the standards
under which their members conduct business; monitoring business
conduct; and bringing disciplinary actions against their members for
violating applicable federal statutes, SEC's rules, and their own
rules. SEC oversees the SROs by inspecting their operations and
reviewing their rule proposals and appeals of final disciplinary
proceedings.
The Securities Exchange Act also created SEC as an independent agency
to oversee the securities markets and their participants. SEC has a
five-member commission headed by a chairman who is appointed by the
President for a 5-year term. In overseeing the SROs' implementation and
enforcement of rules, SEC may use its statutory authority to, among
other things, review and approve SRO-proposed rule changes and abrogate
(or annul) SRO rules.
The futures market's regulatory structure consists of federal oversight
provided by CFTC and industry oversight provided by SROs--the futures
exchanges and the National Futures Association (NFA). Futures SROs are
responsible for establishing and enforcing rules governing member
conduct and trading; providing for the prevention of market
manipulation, including monitoring trading activity; ensuring that
futures industry professionals meet qualifications; and examining
members for financial strength and other regulatory purposes. Their
operations are funded by the futures industry through transaction fees
and other charges. In regulating the futures market, CFTC independently
monitors, among other things, exchange trading activity, large trader
positions, and certain market participants' financial condition. CFTC
also investigates potential violations of the Commodity Exchange Act
and CFTC regulations and prosecutes alleged violators. Additionally,
CFTC oversees the SROs to ensure that each has an effective self-
regulatory program. In this regard, CFTC designates and supervises
exchanges as contract markets and NFA as a registered futures
association, audits SROs for compliance with their regulatory
responsibilities, and reviews SRO rules and products that are traded on
designated exchanges.
States Have Primary Responsibility for Regulating Insurance Entities:
Unlike other financial service sectors, the U.S. insurance industry is
regulated primarily at the state level.[Footnote 13]To help coordinate
their activities, state insurance regulators established a central
structure, the National Association of Insurance Commissioners (NAIC),
in 1871. Members of this organization are the heads of the insurance
departments of 50 states, the District of Columbia, and 4 U.S.
territories and possessions. NAIC's basic purpose is to encourage
consistency and cooperation among the various states and territories as
they individually regulate the insurance industry. To that end, NAIC
promulgates model insurance laws and regulations for state
consideration and provides a framework for multistate examinations of
insurance companies. State insurance regulators have tended to stress
safety and soundness issues, but have also taken action in the conduct-
of-business area, especially with regard to sales practices. The
McCarren-Ferguson Act of 1945 generally asserted the view that
insurance regulation should be undertaken by the states.
Some U.S. Regulators Engage in Holding Company Oversight:
Many of the largest financial legal entities are part of holding
company structures--companies that hold stock in one or more
subsidiaries. Many companies that own or control banks are regulated by
the Federal Reserve as bank holding companies, and their nonbanking
activities generally are limited to those that the Federal Reserve has
determined to be closely related to banking. Under the Gramm-Leach-
Bliley Act (GLBA), bank holding companies can qualify as financial
holding companies and thereby engage in a range of financial activities
broader than those permitted for "traditional" bank holding companies.
Savings and loan or thrift holding companies (thrift holding
companies), which own or control one or more savings and loan
companies, are subject to supervision by OTS and, depending upon the
circumstances of the holding company structure, may not face the types
of activities restrictions imposed on bank holding companies.
Investment bank holding companies that have a substantial presence in
the securities markets can elect to be supervised by SEC as a
supervised investment bank holding company (SIBHC) if the holding
company does not own or control certain types of banks. Holding
companies that own large broker-dealers can elect to be supervised by
SEC as consolidated supervised entities (CSE). SEC would provide
groupwide oversight of these entities unless they are determined to
already be subject to "comprehensive, consolidated supervision" by
another principal regulator. While holding company supervisors oversee,
to varying degrees, the holding company, the appropriate functional
regulator, as described above, remains primarily responsible for
supervising any functionally regulated subsidiary within the holding
company.
Bank and Financial Holding Companies:
The Bank Holding Company Act of 1956, as amended, generally requires
that holding companies with bank subsidiaries register with the Federal
Reserve as bank holding companies.[Footnote 14] Among other things, the
Bank Holding Company Act restricts the activities of bank holding
companies to those the Federal Reserve determined, as of November 11,
1999, to be closely related to banking. However, under amendments to
the Bank Holding Company Act made in 1999 by GLBA, a bank holding
company can qualify as a financial holding company that, under GLBA,
may engage in a broad range of additional financial activities, such as
securities and insurance underwriting. The Federal Reserve has primary
authority to examine and supervise a bank holding company, financial
holding company, and their respective nonbank affiliates, except for
those that are "functionally regulated" by some other
regulator.[Footnote 15] The Federal Reserve's authority to require
reports from, examine, or impose capital requirements on a functionally
regulated affiliate is limited. For example, the Federal Reserve has
limited authority under GLBA to examine broker-dealer affiliates of
bank and financial holding companies. These limitations were designed
to lessen the regulatory burden on and provide for consistent
regulation of a financial activity, such as securities, regardless of
whether the entity conducting the activity is affiliated with a
commercial bank. In this report, we sometimes refer to banks, bank
holding companies, and financial holding companies as banking
organizations.
Thrift Holding Companies:
Under the Home Owners' Loan Act of 1933, as amended, companies that own
or control a savings association are subject to supervision by OTS.
Historically, most thrift holding companies were designated as "exempt"
and permitted to engage in a wide range of activities, including
insurance, securities, and nonfinancial activities.[Footnote 16]GLBA
expanded the activities authorized for nonexempt thrift holding
companies to include those authorized for financial holding companies.
However, GLBA curtailed the availability of exempt status to only those
that meet all of the following criteria: the organization was a thrift
holding company on May 4, 1999, or became a thrift holding company
under an application pending with OTS on or before that date; the
holding company meets and continues to meet the requirements for an
exempt thrift holding company; and the thrift holding company continues
to control at least one savings association (or successor savings
association) that it controlled on May 4, 1999, or that it acquired
under an application pending with OTS on or before that date. As a
result, GLBA in effect redefined the requirements for an exempt thrift
holding company.
SEC's Consolidated Supervision:
Beginning with the Market Reform Act of 1990, SEC has been undertaking
supervisory activities aimed at assessing the safety and soundness of
securities activities at a consolidated or holding company
level.[Footnote 17] That act authorized SEC to collect information from
registered broker-dealers about the activities and financial condition
of their holding companies and material unregulated affiliates. In
1992, SEC began receiving risk-assessment reports from firms that
permitted it to assess the potential risks that affiliated
organizations might have on broker-dealers. By June 2001, SEC was
meeting monthly with major securities firms in connection with their
risk reports. SEC rules regarding more complete oversight of the
activities of some holding companies--SIBHC and CSE--became effective
in August 2004.[Footnote 18] GLBA had amended the Securities Exchange
Act of 1934 to permit an investment bank holding company that is not
affiliated with certain types of banks and has a subsidiary broker-
dealer with a substantial presence in the securities markets to elect
to become an SIBHC and be subject to SEC supervision on a groupwide
basis. SEC established a similar set of rules for holding companies
with the largest broker-dealers to voluntarily consent to consolidated
supervision by becoming a CSE. Under the CSE rules, broker-dealers may
apply to SEC for a conditional exemption from the application of the
standard net capital calculation and, instead, use an alternative
method of computing net capital that permits utilization of
mathematical modeling methods. As a condition for granting the
exemption, broker-dealers' ultimate holding companies must consent to
capital requirements consistent with Basel standards and groupwide SEC
supervision unless they are determined to already be subject to
"comprehensive, consolidated supervision" by another principal
regulator. For companies that choose to become SIBHCs or CSEs, SEC
would have supervisory authority over OTC derivatives transactions
undertaken in previously unregulated affiliates.
Federal Reserve and U.S. Treasury Play Roles in Maintaining Financial
Stability:
As the U.S. central bank, the Federal Reserve also has responsibility
for ensuring financial stability. In practice, this has entailed
providing liquidity to financial markets during periods of crisis. For
example, in the immediate aftermath of the September 11, 2001, attacks,
the Federal Reserve provided about $323 billion to banks to overcome
problems that resulted from the inability of a major bank to clear
trades in government securities. In addition, the Federal Reserve is
also both a provider and regulator of clearing and payment
services.[Footnote 19]
The Department of the Treasury shares in the responsibility for
maintaining financial stability and has other responsibilities related
to financial institutions and markets as well. Treasury shares
responsibility for managing systemic financial crises, coordinating
financial market regulation, and representing the United States on
international financial market issues. Treasury, in consultation with
the President, may also approve special resolution options for
insolvent financial institutions whose failure could threaten the
stability of the financial system. Two-thirds of the members of the
Federal Reserve's Board of Governors and of the FDIC Directors must
approve any extraordinary coverage.
The United States Participates in International Organizations Dealing
with Regulatory Issues:
U.S. regulators meet with regulators from other nations in a number of
different forums:
* Basel Committee on Banking Supervision (Basel Committee). Agency
principals from OCC, FDIC, and the Federal Reserve[Footnote 20]
participate as members in the Basel Committee, along with central bank
and regulatory officials of other industrialized countries.[Footnote
21] The committee formulates broad supervisory standards and
guidelines, including those for capital adequacy regulation, and
recommends best practices in the expectation that individual
authorities will take steps to implement them through detailed
arrangements--statutory or otherwise--that are best suited for their
own national systems. One of the objectives of the Basel Committee is
to close gaps in international supervision coverage so that no
internationally active banks escape supervision and supervision is
adequate. The committee encourages convergence toward common approaches
and common standards without attempting detailed harmonization of
member country supervisory techniques.
* International Organization of Securities Commissions (IOSCO). IOSCO
is the principal international organization of securities commissions,
and is composed of securities regulators from over 105 countries. SEC
is a member of IOSCO, and CFTC participates as an associate member.
IOSCO develops principles and standards for improving cross-border
securities regulation, reviews major securities regulatory issues, and
coordinates practical responses to these concerns. Areas addressed by
IOSCO include: multinational disclosure, accounting, auditing,
regulation of the secondary markets, regulation of intermediaries,
enforcement and the exchange of information, investment management,
credit rating agencies, securities analysts' conflicts of interest, and
securities activity on the Internet.
* International Association of Insurance Supervisors (IAIS).
Established in 1994, IAIS represents insurance supervisory authorities
of some 180 jurisdictions. It was formed to promote cooperation among
insurance supervisors, set standards for insurance supervision and
regulation, provide training for members, and coordinate work with
regulators in the other financial sectors and international financial
institutions. NAIC works with IAIS.
* Joint Forum. Established in early 1996 under the aegis of the Basel
Committee, IAIS, and IOSCO, the Joint Forum publishes papers addressing
supervisory issues that arise from the continuing emergence of
financial conglomerates and the blurring of distinctions between the
banking, securities, and insurance sectors.[Footnote 22] The Joint
Forum comprises an equal number of senior insurance, bank, and
securities supervisors representing 13 countries.[Footnote 23]
* Financial Stability Forum (FSF). Convened in April 1999, FSF brings
together national authorities responsible for financial stability in
significant international financial centers, international financial
institutions, sector-specific international groupings of regulators
and supervisors, and committees of central bank experts. FSF seeks to
coordinate the efforts of these various bodies in order to promote
international financial stability, improve the functioning of markets,
and reduce systemic risk. The Federal Reserve, SEC, and Treasury
participate in FSF.
The International Monetary Fund (IMF) also plays a role in promoting
effective regulation of financial services. IMF is an organization of
184 countries, working to foster global monetary cooperation, secure
financial stability, facilitate international trade, promote high
employment and sustainable economic growth, and reduce poverty. As part
of its surveillance activities, IMF and the World Bank have taken a
central role in developing, implementing, and assessing internationally
recognized standards and codes in areas that are crucial for the
efficient functioning of a modern economy, including central bank
independence, financial sector regulation, corporate governance and
policy transparency, and accountability. In response to banking crises
in the 1990s, they created the Financial Sector Assessment Program to
assess the strengths and weaknesses of countries' financial sectors.
The staffs of these institutions also conduct research related to these
activities.
These international institutions and forums have generally agreed on a
set of principles or prerequisites for achieving the objectives of
financial regulation. These generally include:
* formulating clear objectives for regulators;
* ensuring regulatory independence, but with appropriate
accountability;
* providing regulators with adequate resources, including staff and
funding;
* giving regulators effective enforcement powers; and:
* ensuring that regulation is cost efficient.
Objectives, Scope, and Methodology:
Our objectives were to describe changes over recent decades in (1) the
financial services industry; (2) the U.S. regulatory structure and
those of several other industrialized countries; and (3) U.S. financial
market regulation, focusing on capital requirements, supervision,
market discipline, and domestic and international coordination. Our
objectives also included assessing (4) U.S. regulators' efforts to
communicate, coordinate, and cooperate with each other and with
regulators abroad, and (5) the strengths and weaknesses of the present
U.S. financial regulatory system. While housing finance is often
considered part of the financial services industry, this report does
not include government-sponsored enterprises with a major role in
housing finance or their regulators.[Footnote 24] In addition, because
credit unions have only about 9 percent of domestic deposits and ILCs
have only 1 percent of domestic deposits, this report does not discuss
them in detail.[Footnote 25] Finally, we have not included pension
funds or their regulator in this report. In addition, we do not discuss
the role of the Federal Trade Commission or the impact of tax policy
on the financial services industry.
To address the objectives of this report, we conducted interviews with
senior supervisory and regulatory officials at the federal level,
including the Federal Reserve, FDIC, OCC, OTS, SEC, and CFTC. At the
state level, we interviewed supervisory and regulatory officials in
Florida, Illinois, Massachusetts, Michigan, Minnesota, and New York as
well as trade associations representing state regulators, including
supervisors of the Conference of State Bank Supervisors, North American
Securities Association of Administrators, and National Association of
Insurance Commissioners. Finally, we spoke to a variety of SROs,
including the New York Stock Exchange (NYSE), NASD (formerly the
National Association of Securities Dealers), Municipal Securities
Rulemaking Board, National Futures Association, Chicago Mercantile
Exchange, Chicago Board of Trade, and Chicago Board Options Exchange.
These agencies provided us with documents and statistics, including
research studies, examination manuals, annual and strategic reports,
performance plans, and financial and budgetary data. In addition to our
interviews with supervisory and regulatory officials, we also met with
officials representing financial services firms and exchanges and their
trade associations, and academic experts. Information about depository
institutions identified in this report was obtained from publicly
available sources.
This report also draws on extensive work we have done in the past on
the financial services regulatory structure and includes information
gathered from many sources. These sources include studies of the
history of the financial services industry; records from congressional
hearings related to regulatory restructuring; and professional
literature concerned with the industry structure and regulation. We
also reviewed relevant banking, securities, insurance, and futures
legislation at the federal level.
To address issues of international harmonization and to compare the
U.S. regulatory regime with more consolidated structures abroad, we
conducted fieldwork in Belgium, Germany, and the United Kingdom. During
our field visit, we interviewed officials from the European Union (EU),
European Central Bank, Financial Services Authority in the United
Kingdom (UK-FSA), The Bank of England, Her Majesty's Treasury (HM-
Treasury), Federal Financial Supervisory Authority in Germany (BaFin),
Deutsche Bundesbank (Bundesbank), and German Treasury. Many of the
officials we interviewed provided us with documents and research
studies on their regulatory processes and the reasons for implementing
more consolidated structures. We also interviewed officials from
financial services firms, including subsidiaries of U.S. firms as well
as two firms headquartered in the countries we visited. In addition, we
spoke with trade associations and other experts on the EU and
regulatory consolidation within various countries. For those countries
we did not visit (Australia, Japan, and the Netherlands), we reviewed
documents and provided our findings for review by government officials
from the relevant country or other recognized experts. We did not
conduct a full legal review of the regulatory regimes for any of these
countries.
To develop certain other information, we collected data from federal
and state regulators and SROs on the resources they devoted to
supervision from 1999 to 2003. We also collected information about
ongoing regular communication these entities had with other regulatory
bodies between January 2003 and March 2004. We did not use any
nonpublic supervisory data in conducting our work for this report.
We provided a draft of this report to the Department of the Treasury,
Board of Governors of the Federal Reserve System, CFTC, FDIC, NAIC,
OCC, OTS, and SEC for review and comment. The written comments of the
Board of Governors, FDIC, OCC, OTS, and SEC are printed in appendixes I
through V and are discussed at the end of chapter 7. The staffs of
these agencies also provided technical comments that have been
incorporated, as appropriate. The Department of the Treasury, CFTC, and
NAIC did not provide written comments, but their staffs provided
technical comments that have been incorporated, as appropriate. We
conducted our work between June 2003 and July 2004 in accordance with
generally accepted government auditing standards in Washington, D.C;
Boston; Chicago; New York City; Brussels, Belgium; London; and Berlin,
Bonn, and Frankfurt, Germany.
[End of section]
Chapter 2: The Financial Services Industry Has Undergone Dramatic
Changes:
The environment in which the financial services industry operates and
the industry itself have undergone dramatic changes that include
globalization, consolidation, conglomeration, and convergence. These
forces have affected financial services firms, markets, and products.
First, globalization that includes the financial services industry has
become a characteristic of modern economic life. Second, consolidation
(merging of firms in the same sector) and conglomeration (merging of
firms in other sectors) have increasingly come to characterize the
large players in the financial services industry. Third, the roles of
financial institutions and the products and services they offer have
converged so that institutions often offer customers similar services,
although sectors still specialize to some extent. As a result of these
changes, as well as the development of innovative financial products,
the financial services industry has become more complex, and thus the
kinds and extent of risks the industry faces have changed.
Financial Services Have Played an Integral Part in Globalization:
Globalization has had a major impact on a broad range of economic
activities, including financial markets. Figure 2, which shows the
ongoing growth of international corporate and sovereign debt,
illustrates the linkages among financial markets around the globe.
Figure 2: International Debt Securities, 1987-2004:
[See PDF for image]
[End of figure]
The financial services industry--firms, markets, and products--have
been an integral part of the globalization trend. At present, firms
have a greater capacity and increased regulatory freedom to cross
borders, creating markets that either eliminate or substantially reduce
the effect of national boundaries. U.S.-owned financial services firms
have increased their international activities, and a significant number
of foreign-owned financial services companies are operating within the
United States. In banking, for example, Citibank has substantial and
growing retail banking activities in Germany and ING Direct, a Dutch-
owned company, has a large deposit base in the United States. In the
securities sector, in 2003 U.S. investors held $2.5 trillion of foreign
securities, and foreign holdings of U.S. securities other than U.S.
Treasury securities rose to $3.4 trillion. In the insurance sector, a
significant portion of U.S. insurers and the U.S. market are now
foreign controlled. In 2001, 142 U.S. life insurers were foreign-owned,
up from 69 in 1995. And, according to the International Insurance
Institute, from 1991 to 1999, sales by foreign-owned property-casualty
insurers doing business in the United States grew by 62.8 percent.
Deregulation and technological change have facilitated globalization.
Barriers that once limited international financial transactions have
been substantially reduced or removed, and greater computing power and
better telecommunications networks have driven the technological
revolution. These technological changes have had a major effect on
wholesale securities and futures markets around the world. Many
securities and futures products can be traded 24 hours a day from any
place in the world. Electronic trading and other changes have made this
transformation possible. Large U.S.-based institutional investors can
now buy stock in publicly traded foreign companies by accessing foreign
stock markets. Smaller retail investors can participate in the equity
markets of foreign countries by buying mutual funds that specialize in
developed or emerging foreign markets.
Large Institutions Have Become Larger through Consolidation and
Conglomeration:
Generally, over the last several decades, large financial institutions
have consolidated by merging with or acquiring other companies in the
same line of business. Consolidation has occurred in all of the
industry segments discussed in this report--banking, securities,
futures, and insurance. While the number of firms declined, the
percentage of industry assets concentrated in the largest 10 commercial
banks, thrifts, life insurers, and property-casualty insurers rose
between 1996 and 2002, as shown in figure 3. While the percentage of
assets of the largest 10 securities firms has fallen somewhat, these
firms still have more than 50 percent of the industry's assets. The
same technological and improvements and deregulation that have driven
globalization have also contributed to consolidation and
conglomeration. While large firms have gotten larger and often account
for an increasing share of each industry, there are still a large
number of firms in each industry segment. Some observers believe that
the financial services sectors will come to be characterized by a few
large players and lots of small, niche-market players, with few in
between.
Figure 3: Share of Assets in Each Sector Controlled by 10 Largest
Firms, 1996-2002:
[See PDF for image]
[End of figure]
The change in the banking sector has been especially dramatic, as it
has been driven by both technological change and significant
deregulation. In the early 1980s, bank holding companies faced
limitations on their ability to own banks located in different states.
Some states did not allow banks to branch at all. With the advent of
regional interstate compacts in the late 1980s, some banks began to
merge regionally. Additionally, the Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994 removed restrictions on bank holding
companies' ability to acquire banks located in different states and
permitted banks in different states to merge, subject to a process that
permitted states to opt out of that authority.[Footnote 26] While the
U.S. banking industry is still characterized by a large number of small
banks and researchers have questioned whether economies of scale and
scope exist, the larger banking organizations have grown significantly
through mergers after 1995. As figure 4 shows, 40 large banking
organizations operating in 1990 had consolidated into 6 banking
organizations by August 2004. These six banking organizations had about
40 percent of total bank assets in the United States.
Figure 4: Merger Activity among Banking Organizations, January 1990-
June 2004:
[See PDF for image]
[End of figure]
Many of the larger financial services firms are part of holding
companies that operate in more than one of the traditional sectors.
These firms are called conglomerates. A research study by IMF staff
shows that based on a worldwide sample of the top 500 financial
services firms in assets, the percentage of firms in the U.S. that are
conglomerates--firms having substantial operations in more than one of
the sectors (banking, securities, and insurance)--increased from 42
percent of the U.S. firms in the sample in 1995 to 61.5 percent in
2000; however, for the sample of U.S. firms, the percentage of assets
controlled by conglomerates declined from 78.6 percent in 1995 to 73
percent in 2000.[Footnote 27] The largest banks in the United States
have brokerage operations, and many sell insurance and mutual fund
products. While much of the conglomeration in the United States took
place prior to GLBA, that important piece of legislation removed
restrictions on the extent to which conglomerates could engage in
banking and nonbanking financial activities, thus, for example, making
it possible for financial conglomerates to purchase insurance companies
and other financial institutions to purchase banks.
To facilitate and recognize the trend toward conglomeration, GLBA
authorized new regulatory regimes. The act authorized bank holding
companies to qualify as financial holding companies and provided for
voluntary SEC supervision of investment bank holding companies. While
rules for the latter were issued only in June 2004, financial holding
companies grew from 477 in 2000 to 630 in March 2003. Metropolitan Life
Insurance Company, one of the largest life insurance companies in the
United States, and Charles Schwab & Co., a sizable securities firm,
acquired or opened banks and became financial holding companies. In
addition, several major insurance and commercial companies, including
American International Group, General Electric, and American Express,
have thrifts and Merrill-Lynch has chartered an ILC in addition to its
commercial bank and thrift. As a result, a consumer can make deposits,
obtain a mortgage or other loan, or purchase insurance products from
the same company. Although some had expected that conglomeration would
intensify after GLBA, as yet, this does not seem to have happened. The
reasons vary: Many firms were already conglomerates before the passage
of GLBA, the removal of some limitations on bank-affiliated broker-
dealers allowed banks to grow internally, banks did not see any
synergies with insurance underwriting, and a general slowdown occurred
in merger and acquisition activity across the economy in the early
2000s. While merger and acquisition activity in banking has picked up,
sizable mergers between firms in different sectors have not
materialized so far. It may be that these mergers are not economically
efficient, the regulatory structure set up under GLBA is not
advantageous to these mergers, or it may simply be too soon to tell
what the impact will be. In addition, some cross-sector mergers have
been unwound. For example, Citigroup sold off the property-casualty
unit of Travelers, which had been affiliated with Citibank since their
merger in 1998.
Roles of Large Financial Services Firms Have Changed and Financial
Products Have Converged, but Some Differences Remain:
Increasingly, financial intermediaries are relying on fee-based
services, including asset management, for their profitability. Firms in
all of the sectors are also increasingly involved in activities to
manage their and their institutional customers' risks. In addition,
product offerings by firms in different segments of the financial
services industry have converged so that product offerings that might
appear to be different are competing to meet similar customer needs,
such as having access to liquid transaction accounts, saving for
retirement, or insuring against the failure of a party to live up to
the terms of a commercial contract.
Market Developments Have Forced Financial Services Firms to Adapt:
Generally, financial services firms, especially banks, have had to
adapt to the ease with which corporations can now directly access
capital markets for financing, rather than depending on loans. For
example, with the emergence of the commercial paper market, many large
firms with strong credit ratings that had been dependent on bank loans
were able to access capital markets more directly. As a result, those
large banks that had been major lenders to these firms have had to find
new sources of revenue. Banks are now relying more on fee-based income
that is generated by structuring and arranging borrowing facilities,
providing risk management tools and products, and servicing the loans
they have sold off to other institutions as well as from fees on
deposit and credit card activity, including account holder fees, late
fees, and transactions fees. Many large banking institutions have moved
into investment banking activities, including arranging OTC derivative
transactions for their corporate customers. These institutions also
earn fees on their investment banking activities as well as from their
sales of insurance and mutual fund products.
These role changes have been facilitated by the development of new
products, such as securitized assets, that depend on sophisticated
mathematical models and the technology needed to support them. In its
simplest form, asset securitization is the transformation of generally
illiquid assets into securities that can be traded in capital markets.
The process includes several steps: the firm that issued the loans
creates a legal entity (a "pool"), segregates loans or leases into
groups that are relatively homogeneous with respect to their cash-flow
characteristics and risk profiles, including both credit and market
risks, and sells the group to the pool. The pool then issues securities
and sells them to an underwriter, who prices them and sells them to
investors. Securitized assets generally consist of mortgage-backed
securities and other asset backed securities where loans for products
such as credit cards or commercial loans are securitized and sold.
Mortgage-backed securities[Footnote 28] grew from about $1,123 billion
in 1990 to about $3,796 billion in 2003, while other asset-backed
securities grew by a factor of 12 over that same period of time.
Because the risk embedded in securitized assets can be structured and
priced so that financial institutions and others may be better able to
manage credit and interest rate risk with these instruments.
Because banks and insurance companies could reduce their capital
requirements by securitizing assets and removing those assets from
their balance sheets, securitization was also driven by changes in
capital requirements implemented in these industries in the early 1990s
that required firms to hold more capital for certain assets.[Footnote
29]
Along with securitized assets, derivatives have been used increasingly
by financial institutions to manage assets and risks for themselves and
others or to take a position on the direction of market movements in
hopes of making a profit. Derivatives are contracts that derive their
value from a reference rate, index, or the value of an underlying
asset, including stocks, bonds, commodities, interest rates, foreign
currency exchange rates, and indexes that reflect the collective value
of underlying financial products. There are several types of
derivatives, including the following:
* Futures and forwards--contracts that obligate the holder to buy or
sell a specific amount or value of an underlying asset, reference rate,
or index (underlying) at a specified price on a specified future date.
Futures and forwards are used to hedge against changes or to speculate
by attempting to make money off of predicting future changes in the
underlying. Futures are often traded on exchanges and forwards are
traded as OTC transactions and generally result in delivery of an
underlying. (See ch. 1.)
* Options--contracts that grant their purchasers the right but not the
obligation to buy or sell a specific amount of the underlying at a
particular price within a specified period. Options can allow their
holders to protect themselves against certain price changes in the
underlying or benefit from speculating that price changes in the
underlying will be greater than generally expected.
* Swaps--agreements between counterparties to make periodic payments to
each other for a specified period. Swaps are often used to hedge market
risk or speculate on whether interest rates or currency values will
change in a particular direction.
* Credit default swaps--a contract whereby the protection buyer agrees
to make periodic payments to the protection seller for a specified
period of time in exchange for a payment in the event of a credit event
such as a default by a third party referenced in the swap. Credit
default swaps allow market participants to keep loans or loan
commitments on their books and essentially purchase insurance against
borrower default.
Figure 5 shows the growth in the number of exchange-traded futures
since 1995.[Footnote 30] In addition, Bank for International
Settlements' estimates of the notional amounts of OTC derivatives
outstanding increased globally by about 146 percent between 1998 and
2003, going from about $80 trillion in 1998 to about $197 trillion in
2003.
Figure 5: Number of Futures Contracts Traded, 1995-2003:
[See PDF for image]
[End of figure]
The growth of derivatives activity attests to the usefulness of these
instruments to the participants, but there are concerns about the
management of derivatives risk. The complexity of some of these
instruments can make it difficult for the users to understand and
estimate the potential value or loss; moreover, the reliance on a
counterparty to make an expected flow of payments during future years
means that the recipient is exposed to the credit risk that the
counterparty might default in the meantime.
Product Offerings in Different Sectors Have Also Converged:
While convergence has taken place among firms using similar securitized
products and derivatives to manage assets and risks, it has also taken
place in product offerings by firms in different segments of the
financial services industry. These firms are competing against each
other to provide households, businesses, and governments with the same
basic services. For example, table 1 illustrates how financial firms in
the various sectors, regardless of whether they are affiliated with
firms in other sectors, are offering functionally similar products to
satisfy the same retail customer needs.
Table 1: Selected Retail Products by Financial Institution and
Function[A]:
Financial institution: Banks;
Transaction accounts: Checking, savings;
Fixed return investments: Certificates of deposit, corporate bonds,
municipal bonds, Treasuries;
Variable return investments: Variable annuities;
Risk management: Insurance distribution[B];
Raising money: Loans (all types).
Financial institution: Broker-dealers;
Transaction accounts: Cash management account;
Fixed return investments: Corporate bonds, municipal bonds, Treasuries;
Variable return investments: Stocks, mutual funds, variable annuities;
Risk management: Options;
Raising money: Loans associated with margin accounts.
Financial institution: Investment companies;
Transaction accounts: Money market mutual fund;
Fixed return investments: Guaranteed investment;
contracts;
Variable return investments: Mutual funds, variable annuities.
Financial institution: Insurers;
Fixed return investments: Fixed annuities, guaranteed investment
contracts;
Variable return investments: Variable annuities, mutual funds;
Risk management: Property-casualty, life insurance.
Financial institution: Futures firms;
Risk management: Futures, options.
Financial institution: Other financing companies;
Variable return investments: Consumer loans.
Source: GAO:
[A] While most of these products could be offered by any financial
institution through its affiliates, the products are classified here
according to whether a stand-alone financial institution would offer
the product.
[B] Subject to a grandfathering provision, GLBA prohibits national
banks from engaging in title insurance activities, except that national
banks and their subsidiaries may act as agents to sell title insurance
in states where state banks are permitted to engage in that activity.
15 U.S.C. 6713 (2000 & Supp. 2004). Also, national banks may underwrite
certain insurance products, such as credit insurance, where the
activity is incidental to the business of banking, and may act as
insurance agents directly only under certain circumstances, although
they may engage fully as insurance agents through subsidiaries.
[End of table]
Similarly, firms in different sectors compete by offering products that
have similar ability to meet some business needs. Issuance of
commercial paper can provide financing similar to commercial loans, and
catastrophe bonds and reinsurance provide similar protection, as do
surety bonds and standby letters of credit.
Although financial services firms and products have converged in
numerous ways, firms in the various sectors, especially smaller firms,
continue to specialize in some traditional functions. Commercial banks
still make commercial loans to businesses, especially those smaller
businesses that may not be able to raise funds directly in capital
markets; insurance firms still underwrite the risks involved in
insuring a life or property or casualty; and investment banks still
underwrite new securities and advise firms on mergers and acquisitions.
As Financial Services Institutions Have Diversified, Introduced New
Products, and Become More Complex, Risks Have Changed:
Globalization, consolidation, conglomeration, and convergence of
financial institutions have changed the risk profile of the
institutions and the linkages among them. Today, a large modern
financial firm may operate in a variety of product and geographic
markets. Figure 6 illustrates how such a complex firm might be
organized.
Figure 6: Structure of a Hypothetical Financial Holding Company:
[See PDF for image]
[End of figure]
Generally, diversification into new geographic and product markets
would be expected to reduce risk, while securitized and derivative
products have given firms new tools to manage risk. Because risks
interact, however, the net result on the risk of an individual
institution or the financial system cannot be definitively predicted.
In addition, managing risks in an environment that crosses industry and
geographic lines along with new products have increased the complexity
of institutions and the industry. As a result of all of these factors,
the risks facing the industry have changed in some ways.
Credit Risks Have Changed as a Result of Industry Changes:
Generally, diversification of borrowers will reduce the credit risk of
a financial services firm, and many of the changes in the industry have
done just that. U.S. banks have consolidated and spread across the
country so that they are no longer operating in a single small town,
city, or state. If a town or even a region falls on hard times and
borrowers increasingly default on loans, the bank, or other institution
that made the loans, may be less affected than they once would have
been, because borrowers in other markets may be enjoying positive
economic circumstances and defaults in those markets may be dropping.
The same is true for firms diversifying their types of products and for
those diversifying to other parts of the world. In addition, by
securitizing loans and selling them off or by using credit derivative
products, individual firms or sectors may also reduce credit risk. For
example, in its Global Financial Stability Report issued in April 2004,
the IMF reported that, for many years, banks have been transferring
risk, especially credit risk, to other financial institutions, such as
mutual funds, pension funds, insurers, and hedge funds.[Footnote 31]
Many of the same forces that may have reduced credit risk for some
institutions, as well as other forces, may have increased risk as well.
For example, while globalization allows for diversification, it also
complicates the evaluation of credit risk. Because bankruptcy laws
differ among countries, the assets of a failed household or corporate
borrower in another country may be less available to U.S. creditors. In
addition, little recourse exists when foreign governments default on
their debt. Further, the extent to which diversification and new
products reduce credit risk depends on how the firm to which the risk
is passed understands, measures, and manages its new markets and
products--as well as the combined risks of old and new exposures. If it
does not manage them well, these normally credit reducing activities
could actually increase credit or other kinds of risks.
The degree to which diversification and new products reduce credit risk
will also depend on the linkages between markets, products, and firms,
and the relationship or correlation among the risks. For example,
securitized products and credit derivatives can allow one institution
to pass on risk to another. Regulators and others have expressed
concern that this risk can become concentrated in a few firms or be
passed to buyers that may be less equipped to handle it. Some research
has been conducted because regulators and others were concerned that
the banking sector was passing credit risk to the insurance sector or
ultimately to households and that these developments could have
implications for overall financial stability.[Footnote 32] For example,
IMF reported in April 2004 that on a global basis the transfer of
credit risk from banks to life insurers might increase financial
stability because life insurers generally hold longer-term liabilities.
However, the report notes that in recent years, many insurers have
changed their products in ways that have begun to shorten the duration
of their liabilities, raising questions about their advantage in
handling credit risk. And as insurers in some parts of the world take
steps to manage their balance sheet risk, they would likely transfer
that risk to others--including the household sector, which might be
less able to manage the risk.
Because financial services firms are competing and cooperating with
each other across traditional industry and geographic boundaries, there
are increased linkages that may not be well understood. Thus, downturns
somewhere in the world, such as those in Russia in 1998 or Mexico in
1995, can have a large impact on all of the major financial
institutions. In addition, if the large financial institutions are
linked to each other as counterparties in various transactions, a major
credit failure at one could send systemic shockwaves through the United
States and even the world's economy.
Many of the concerns raised here were evident in the near collapse of
Long-Term Capital Management (LTCM)--one of the largest U.S. hedge
funds--in 1998 following the Russian downturn.[Footnote 33] Most of
LTCM's balance sheet consisted of trading positions in government
securities of major countries, but the fund was also active in
securities markets, exchange-traded futures, and OTC derivatives.
According to LTCM officials, LTCM was counterparty to over 20,000
transactions and conducted business with over 75 counterparties.
Further, the Bank for International Settlements reported that LTCM was
"perhaps the world's single most active user of interest rate swaps."
[Footnote 34] In addition many of the financial institutions that LTCM
dealt with failed to enforce their own risk management standards.
Comparing the largest U.S. financial firms today with some large
failures resulting from credit risk that did not appear to have
systemic implications in the past can help shed light on the potential
for systemic disruptions today. Bank of New England, which failed, in
part, because of bad real estate loans, had $19.1 billion in assets at
the time of its failure. In comparison, the largest bank holding
company today had bank subsidiaries with assets of $823 billion in
March 2004. Similarly, in the insurance area, one of the largest U.S.
insurers has assets of $678 billion, while the largest insurance
failure on record is Mutual Benefit, which had assets of only $13.5
billion. While the unwinding of Drexel, Burnham, Lambert Group is
sometimes pointed to as evidence that the failure of a major securities
firm would not necessarily raise concerns about systemic risk
sufficient to warrant intervention, some experts suggest that four
trends in the international financial system since that collapse
suggest that the outcome for a future failure of a major securities
firm might be different:[Footnote 35] (1) Leading securities firms have
become increasingly international, operating in markets around the
world and through a complex structure of affiliates in countries with
differing bankruptcy regimes; (2) securities firms are increasingly
parts of conglomerates that include banks, and thus the systemic
concerns related to bank failures might extend to securities firms; (3)
securities firms themselves have grown in size so that while they may
be less likely to fail, any failure is more likely to have systemic
implications; and (4) the largest securities firms have become
increasingly involved in global trading activities, particularly OTC
derivatives. An SEC staff member told us that while they believe that a
gradual unwinding of one of the largest securities firms today could
still be handled without systemic implications, the sudden failure of
one of these firms would likely have major implications for a broad
swath of markets and investors. Because of the sheer size of today's
financial institutions, some question whether these firms are too big
to be allowed to fail. This belief could skew the incentives facing
managers and investors to manage risk effectively.
Other Risks Have Also Been Affected by Changes in the Industry:
Changes in the industry, especially the growth of large institutions
that cross industry and national boundaries, have also affected the
level and management of operational and reputation risk. An official at
one of the large securities firms told us that opportunities for fraud
or other violations of law or regulation in some part of the
organization increase immediately after a merger of entities with
different corporate cultures. And to the extent that a firm operates
centrally and the public believes the parts are connected, the ability
to isolate such problems in some part of an organization will be more
difficult. The collapse of Barings, a British bank, demonstrates the
potential vulnerability to operational risk of firms operating across a
wide range of markets. In this case, management did not effectively
supervise a trader in Singapore, and his actions brought down the
bank.[Footnote 36] Further, a firm's reputation can be damaged by
disreputable practices, such as happened when a major institution
violated derivatives sales practices and when it was discovered that
ownership of a U.S. bank in Washington, D.C., was tied to BCCI, a
corrupt bank headquartered in Luxembourg. Regulators have recognized
the increased importance of operational risks, including reputation
risk, in the new capital standards adopted by the Basel Committee in
June 2004. (See ch. 4.)
[End of section]
Chapter 3: While Some Countries Have Consolidated Regulatory
Structures, the United States Has Chosen to Maintain Its Structure:
Since the mid-1990s, several major industrial countries, including
Australia, Germany, Japan, the Netherlands, and the United Kingdom,
have consolidated their regulatory structures, and some U.S. states
have consolidated their structures as well. While proposals have been
advanced that would change the U.S. regulatory structure, the United
States, most notably with the passage of GLBA, has chosen not to adopt
any substantial changes. Proposals to change the U.S. regulatory
structure made throughout the 1990s and early 2000s included
consolidating bank regulators, merging SEC and CFTC, changing the SRO
structure for securities, and creating a federal regulator to oversee
those companies opting for the proposed federal insurance charter.
Proposals have also been made that would cut across sectors, including
proposals for a single federal regulator in each area, an oversight
board, and a fully consolidated federal regulator.
Some Countries and States Have Consolidated Their Regulatory
Structures:
During the 1990s and early 2000s, some other countries consolidated
their regulatory structure. According to a research report by World
Bank staff,[Footnote 37] by 2002, 29 percent of the countries that
supervise banking, securities, and insurance had consolidated their
regulatory structure to include only a single regulator, and another 30
percent of the countries had consolidated regulators across two of the
three sectors. The remaining countries had multiple regulators, with a
minimum of one for each of the sectors. Countries within the
EU[Footnote 38] made changes that sometimes reflect steps to create an
integrated financial market but not an EU-wide regulatory regime.
Generally, these countries' industries and regulatory structures
historically had differed from those in the United States, largely
because banking, securities, and insurance activities had not been
legally separated as they were in the United States under the Glass-
Steagall Act. The products and services that financial services firms
in these countries offered had changed, however, reflecting the
financial innovations that have also transformed the U.S. financial
services industry. Some U.S. states have also consolidated their
regulatory structure. In addition, many states have combined some
aspects of their banking, insurance, and securities regulators, and
some have chosen to combine all of their financial regulation in a
single government agency.
The EU Has Taken Steps Designed to Create an Integrated Financial
Market but Not an EU-Wide Regulatory Regime:
EU member states that have consolidated their regulatory structures
have done so in the larger context of efforts to create an integrated
financial market in the EU. Building on long-term actions to create a
single financial market in Europe, the EU has taken several actions
that are influencing regulatory frameworks in European countries.
First, in 1998 the European Central Bank was established, and this has
diminished the roles of the central banks in countries that began using
the euro in 2002.[Footnote 39] Second, the European Commission proposed
an extensive Financial Services Action Plan (Action Plan) in 1999 that
it expects to fully implement by 2005. Under the Action Plan, the EU
would not create any EU-wide financial services regulatory bodies, but
would instead enact legislation that would be adopted by the individual
countries and implemented by their regulators. Since under the EU
charter, firms can do business in all EU countries if they are located
in one of them (the so-called Single Passport), EU officials and others
have said that convergence is necessary to prevent duplicative
requirements and regulatory arbitrage. That is, companies should not
have an incentive to choose their location based on the regulatory
regime in a particular country and should not be able to pit one
regulator against another to get favorable regulatory decisions.
Finally, to streamline European lawmaking and stimulate regulatory and
supervisory convergence, the EU has created a process under which
committees of securities, banking, and insurance regulators from the
individual member states now consult and coordinate their work at
several stages in the process between adoption of more detailed rules.
These supervisory committees are the Committee of European Securities
Regulators (CESR), the Committee of European Banking Supervisors, and
the Committee of European Insurance and Occupational Pensions
Supervisors.
The United Kingdom, Germany, and Japan Have Adopted a Single Regulator
Structure:
Along with other countries, the United Kingdom, Germany, and Japan have
each adopted versions of the single regulator model. However, the
regulatory organizations in these countries differ significantly. The
United Kingdom's consolidation is the most notable in that, according
to a research paper by IMF staff, it provided an enormous impetus for
other countries to unify their supervisory agencies.
United Kingdom:
Beginning in 1997, the United Kingdom consolidated its financial
services regulatory structure, combining nine different regulatory
bodies, including SROs, into the Financial Services Authority (UK-FSA).
While UK-FSA is the sole supervisor for all financial services, other
government agencies, especially the Bank of England and Her Majesty's
Treasury (HM-Treasury), still play some role in the regulation and
supervision of financial services. Formal financial regulation and
supervision are relatively new to the United Kingdom; before 1980,
according to officials at the Bank of England, a "raised eyebrow" from
the Head of the Bank of England was used to censure inappropriate
behavior. Thus, most of the agencies and SROs that were replaced did
not have long histories.
Government officials and experts cited important changes in the
financial services industry as some of the reasons for consolidating
the regulatory bodies that oversee banking, securities, and insurance
activities. These included the blurring of the distinctions between
different kinds of financial services businesses, and the growth of
large conglomerate financial services firms that allocate capital and
manage risk on a groupwide basis. Other reasons for consolidating
included some recognition of regulatory weaknesses in certain areas and
enhancing the United Kingdom's power in EU and other international
deliberations.
U.K. officials have reported that the United Kingdom did not separate
its regulators by objective--the twin peaks model, which usually
includes a prudential or safety and soundness regulatory agency and a
conduct-of-business or market conduct regulatory agency--because the
same senior management and groupwide systems and controls that
determine a firm's ability to manage financial risk effectively also
determine a firm's approach to market conduct. Similarly, while British
experts acknowledge that groupwide supervision could be managed with
regulators who specialize in the regulation of specific sectors, they
say that the need for communication, coordination, cooperation, and
consistency across the specialist regulatory bodies would make it
exceedingly difficult to operate within a multiple regulator system.
According to documents provided by UK-FSA officials, the agency's
enabling legislation stipulated four goals:
* maintaining confidence in the financial system;
* promoting public understanding of the financial system;
* securing the appropriate degree of protection for consumers; and:
* reducing the potential for financial services firms to be used for a
purpose connected with financial crime.
In pursuing these goals, UK-FSA is directed to take account of
additional obligations, including achieving its goals in the most
efficient and effective way; relying on senior management at financial
services companies for most regulatory input; applying proportionality
to regulatory decisions, including the costs and benefits of each act;
not damaging the competitive position of the United Kingdom
internationally; and avoiding any unnecessary distortions in or
impediments to competition, including unnecessary regulatory barriers
to entry or business expansion.
UK-FSA is organized as a private corporation with a chairman and chief
executive officer and a 16-person board of directors. Eleven members of
the board are independent, while the other five are UK-FSA officials.
UK-FSA is ultimately answerable to HM-Treasury and the British
Parliament. The statute provides for a Practitioner Panel and a
Consumer Panel to oversee UK-FSA for their respective constituencies.
In addition, there are requirements for consultation on rules and an
appeals process for enforcement actions.
UK-FSA documents and officials present UK-FSA as an organization
strategically focused on achieving its statutory objectives. It has
adopted a risk analysis model that it believes allows it to allocate
resources so as to minimize the chance that UK-FSA will fail to meet
its goals. As a result of this analysis, it focuses on the largest
firms--the ones most likely to pose significant costs of failure--and
on the needs of retail consumers. To assure that UK-FSA accomplishes
its goals efficiently, it is required to submit cost-benefit analyses
for its proposals. In addition, UK-FSA must report annually on its
costs relative to the costs of regulation in other countries and must
provide its next fiscal year's budget for public comment three months
prior to the end of the current fiscal year.
UK-FSA officials say that they have also taken actions, within the
institution, to break down the barriers--often called stovepipes or
silos--between those regulating the different industries. From the
beginning, they forged a new common language across industry segments
and traditional regulatory boundaries. Staff have to explain why a
requirement imposed on one segment should differ from that imposed on
other sectors. The current organizational structure is designed around
retail and wholesale divisions. The structure also includes
crosscutting teams looking at various issues, including asset
management, financial crime, and financial stability as well as the
traditional areas of banking, securities, and insurance.
Most of the representatives of firms we spoke to in the United Kingdom,
including U.K. subsidiaries of U.S. companies, felt that UK-FSA was
doing a good job, but some industry representatives have raised
concerns. Much of UK-FSA's success is attributed to the caliber of the
people working there. For example, we heard that the ability to pull
off the creation of UK-FSA depended greatly on the caliber of the early
leadership and that using high-quality bank supervisors to supervise in
other areas has had benefits, even though these staff may not have
expertise specific to a particular business. However, some industry
participants were concerned about the future and about the lack of
expertise in some areas such as insurance. In addition, the
Practitioner Panel in its 2003 annual report expressed concerns about
UK-FSA's cost-benefit analyses, saying that certain costs are often
unrepresentative or not included at all, and that there is a disregard
for the total cost of regulation and the industry's ability to absorb
the incremental cost of rule changes. They also suggested that analyses
should include potential areas of consumer disadvantage, such as a
reduction in choice and the possibility of unintended consequences.
However, a UK-FSA official said that while the agency is working to
improve its cost-benefit analysis, one industry trade association
working on the issue had noted that UK-FSA is a world leader in the
area.
Since UK-FSA took over, a major crisis in the life insurance area has
come to light. Equitable Life is a mutual insurer in the United Kingdom
that inappropriately sold policies in the high interest rate
environment in the 1970s and 1980s that are now coming due and failed
to reserve appropriately for them. A major study of this problem, the
Penrose report, was issued in March 2004. The report concluded that the
crisis was due to the "light touch, reactive regulatory environment"
that preceded UK-FSA and that UK-FSA's work since 1997 "has sought to
anticipate many of the lessons that might be drawn by this inquiry and
it should come as no surprise that it has largely succeeded." The
report also concluded that the lack of coordination between safety and
soundness and market conduct regulation in the past was unacceptable.
HM-Treasury is now undertaking an extensive review of UK-FSA's
authorizing legislation, in part, to determine the impact UK-FSA might
be having on competition in the U.K. financial services sector.
While UK-FSA is the sole financial services supervisor, other
government entities still play a role in regulating the financial
services industry. A tripartite agreement lays out the roles of the
Bank of England, HM-Treasury, and UK-FSA. While UK-FSA is responsible
for supervision of financial entities, the Bank of England retains
primary responsibility for the overall stability of the financial
system. It retains the lender of last resort responsibilities but must
consult with HM-Treasury if taxpayers are at risk. High-level
representatives from the three agencies meet monthly to discuss issues
of mutual concern. According to officials at the Bank of England, it is
difficult to tell how well the system is working because it has not yet
had to weather a significant banking crisis.
Germany:
In 2002, Germany combined its securities, banking, and insurance
regulators into BaFin; however, the changes appear less dramatic than
at UK-FSA. Although crosscutting groups have been added to handle
conglomerate supervision, international issues, and other cross-
sectoral topics that concern all of the supervisory divisions, the new
structure still maintains the old divisions related to banking,
securities, and insurance. In addition, the insurance and banking
divisions are housed in Bonn, while the securities markets regulators
are in Frankfurt. Finally, BaFin shares supervisory responsibilities in
the banking area with the Bundesbank, Germany's central bank.
Organizationally, BaFin is a federal agency overseen by the treasury
that must follow civil service laws. BaFin has an administrative board
composed of the ministers of Finance, Economics, and Justice, members
of Parliament, officials of the Bundesbank, and representatives of the
banking, insurance, and securities industries. The Advisory Council
made up of industry, union, and consumer representatives also advises
BaFin.
BaFin's statutory mandate is to take supervisory or enforcement actions
to counteract developments that may:
* endanger the safety and soundness of the assets entrusted to
institutions in the banking, insurance, and other financial services
sectors;
* impair the proper conduct of banking, insurance, and securities
business or provision of financial services; or:
* involve serious disadvantages to the German economy.
Much of the immediate impetus for the creation of BaFin came from
developments in the EU. However, the new organization also recognizes
the blurring of industry lines and the need for reducing the costs of
supervision to the government. Specifically German government officials
cited the following reasons for the creation of a consolidated
regulator:
* Financial institutions that are taking on similar risks must be
treated the same.
* Conglomerates need effective oversight.
* The cost of regulation could be reduced through greater efficiency
and by providing for industry funding of BaFin's operations.
* The role of the Bundesbank, in light of the creation of the European
Central Bank, would be clarified.
* International standing and clout could be increased.
Like the United States, Germany has a state system of financial
institutions and regulators as well as the federal system. The banking
system consists of private banks and state banks, or Sparkassen, that
are owned by a city or other government entity. The fragmentation of
the banking industry has impacted the commercial banking industry in
that private banks have difficulty expanding their retail banking
operations. In addition, securities exchanges, as well as some
insurance activities, are overseen at the state level.
Statutes and agreements lay out the complex relationship between BaFin
and the Bundesbank. When we last reviewed the German bank regulatory
system in 1995, we noted that while the Bundesbank played a role in the
oversight of banks, this role was not then spelled out statutorily.
With creation of the European Central Bank, the role of the Bundesbank
in the supervision of credit institutions was also clarified. While
BaFin conducts its own document analyses and, if required, its own
investigations of troubled institutions and institutions of relevance
to the system, BaFin is required to consult with the Bundesbank on new
rules, and the Bundesbank is responsible for most of the ongoing
monitoring of institutions. Officials at one of the German subsidiaries
of a U.S. investment bank we spoke with said that most of their
dealings are with the Bundesbank.
Japan:
Japan consolidated and modified its financial services regulatory
structure in response to persistent problems in that sector. Japan's
financial markets sector had certain similarities to that of the United
States. Most notably, until 1996, Japan maintained legal separations
between commercial banking, investment banking, and insurance. Japanese
law, however, did allow cross ownership of financial services and
commercial firms, permitting development of industrial groups or
keiretsu that dominated the Japanese economy. These groups generally
included a major or lead bank that was owned by other members of the
group and that provided financial services to the members.
Problems in Japan's financial sector are generally accorded some
responsibility for the persistent stagnation of its economy through the
1990s. The Financial Reform Act of 1992 allowed the Ministry of Finance
to impose capital requirements for banks and banks to own securities
affiliates and created the Securities Exchange and Surveillance
Commission. According to one author, while these laws were designed to
reduce the Ministry of Finance's control over the financial sector, the
ministry retained its role. In 1998, the Financial Supervisory Agency,
renamed the Financial Services Agency (Japan-FSA) in 2000, was created,
with functions and staff transferred from the Ministry of Finance. The
Securities Exchange and Surveillance Commission was also moved into
that organization. Japan-FSA has overseen the mergers of several large
banks and reports progress in addressing the issue of nonperforming
loans held by Japanese banks. In the review of Japan-FSA issued in
2003, however, IMF raised questions about the independence and
enforcement powers of the agency.
The Netherlands and Australia Have Consolidated Their Regulatory
Structure Using the Twin Peaks Model:
Both the Netherlands and Australia consolidated their regulatory
structure, but they did not adopt the single regulator structure.
Instead, they adopted a structure that separates the regulators by
objective,[Footnote 40] such that one regulatory body is responsible
for prudential regulation and another for conduct-of-business
regulation--often referred to as the twin peaks model.
In 2001, when the Netherlands Ministry of Finance proposed a
restructuring of the financial regulatory structure, the country had
three regulatory bodies--the Dutch Central Bank regulated banks, the
Pensions and Insurance Supervisor regulated insurance, and the
Securities Board regulated securities. Both the Central Bank and the
Insurance Supervisor had some responsibility for financial stability.
Since 1999, the Council of Financial Supervisors had helped to
coordinate regulatory activities between the three agencies, but has
received less attention as the country moves to the new structure.
The Netherlands is now in the final stages of consolidating its
regulatory system and separating it into prudential and market conduct
activities. The Pensions and Insurance Supervisor is merging with the
Dutch Central Bank so that all prudential supervision will be done
within the central bank, and in 2003, the Securities Board became the
Netherlands Authority for the Financial Markets (AFM), the body
responsible for market conduct in all segments of financial services.
As with the other countries, several factors contributed to the
Netherlands' decision to change its regulatory structure. The
Netherlands is the home of several of the largest, most globally active
conglomerates. Supervision of these conglomerates had been divided
among the three regulatory bodies and was not always consistent. As
with the other central banks of other countries that adopted the Euro,
the Dutch Central Bank no longer has primary responsibility for
monetary policy or for the nation's currency. Like Germany, the
Netherlands needed to clarify the role of its central bank after the
formation of the European Central Bank.
With regard to its regulatory and supervisory roles, the Dutch Central
Bank operates as an autonomous administrative authority. After the
merger with the Pensions and Insurance Supervisor, its main objective
is to ensure that banks, insurance companies, pension funds, and other
financial service providers are sound businesses that can meet their
liabilities to others now and in the future. The supervision focuses on
protecting as well as possible the interests of consumers of financial
services, whether they are individuals or businesses.
A three-person executive board, subject to oversight by a five-person
supervisory board appointed by the Minister of Finance, manages AFM.
According to its 2003 Annual Report, this authority's objectives are
to:
* promote access to financial markets;
* promote the efficient, fair, and orderly operation of financial
markets; and:
* ensure confidence in financial markets.
AFM is not organized around traditional industry sectors, but around
three clusters of activities: Supervision Preparation, Supervision
Implementation, and Business Operations.
In 1998, Australia's regulatory reforms provided for the establishment
of the Australian Prudential Regulation Authority (APRA) to regulate
the safety and soundness of financial institutions and the Australian
Securities and Investments Commission (ASIC) to regulate corporations,
market conduct, and consumer protection in relation to financial
products and services. These changes followed a major study of
Australia's regulatory regime--called the Financial System Inquiry or
Wallis Report--that reported to the Australian Government in March
1997. This report identified the following reasons for recommending
reform:
* to achieve a more competitive and efficient financial system while
maintaining financial market stability, prudence, integrity, and
fairness;
* to design a regulatory framework that is adaptable to future
financial innovations and other market developments; and:
* to ensure that the regulation of similar financial functions,
products, or services is consistent between different types of
institutions.
APRA, the safety and soundness regulator, provides prudential
regulation for deposit-taking institutions, insurers, and pension
funds. APRA consolidated prudential regulation responsibilities at the
national level, taking on the responsibilities of nine regulatory
agencies (the Reserve Bank of Australia, the Insurance Superannuation
Commission and seven state-based regulators). It is an independent
authority that is overseen by a three-person executive group. Its
structure includes a risk management and audit committee and has four
major divisions--diversified institutions, specialized institutions,
supervisory support and policy, research and statistics.
ASIC is an independent commonwealth government body that has
responsibility for regulating financial markets and corporations as
well as consumer protection in relation to the provision of financial
products and services, including securities, derivatives, pensions,
insurance, and deposit taking. As one ASIC official put it, ASIC looks
after consumers as individual customers, ensuring they receive proper
disclosure, are dealt with fairly by qualified people, and continue to
receive useful information about their investments. ASIC replaced the
Australian Securities Commission, which had replaced the National
Companies and Securities Commission at the federal level and the
Corporate Affairs offices of the states and territories in 1991.
Along with APRA and ASIC, the Wallis report recommended that a Council
of Financial Supervisors, initially composed of representatives of
APRA, ASIC, and the central bank, be formed to deal with issues of
coordination and cooperation. The council comprises high-level
executives from each group and meets at least quarterly to discuss
issues of mutual interest. As part of regulatory reforms flowing from a
recent significant failure of an insurer, representatives of the
treasury have also been included on the council.
Some U.S. States Have Also Consolidated Their Regulatory Structures
Largely in Response to Industry Conglomeration and Product Convergence:
According to information provided by the Conference of State Bank
Supervisors, in July 2004, 23 states supervise banking and either
insurance or securities in one department. That information also shows
that 14 states have consolidated financial regulatory structures,
combining banking, securities, and insurance regulation into one
department.[Footnote 41] We interviewed officials in large states--
Florida, Michigan, and Minnesota--that had consolidated their
regulatory structures. Regulatory officials from each of these states
told us they consolidated in response to industry changes that were
blurring the traditional demarcations between banking, securities, and
insurance activities. In all three states, officials said that although
consolidation was not designed to conserve resources, they believed
there had been cost savings due to consolidation.
State officials from Florida, Michigan, and Minnesota told us that
consolidation had improved information sharing across different
financial services sectors, specifically in the areas of licensing and
customer complaints. Michigan has consolidated licensing of all sales
agents, including mortgage, insurance, and securities. Now that all
financial licensing is housed in one division, the state can more
easily detect and discipline fraudulent behavior. For instance,
individuals who have recently lost their license to sell securities due
to fraudulent or other criminal acts cannot apply for a license to sell
insurance or mortgages. Consolidation of customer complaints call
centers has enabled Florida, Michigan, and Minnesota to downsize
personnel and provide better services to consumers of financial
products, according to officials from those states.
United States Has Chosen to Maintain the Federal Regulatory Structure,
although Proposals Have Been Made to Change It:
While GLBA removed restrictions against affiliations among financial
services providers across sectors, it did not change the financial
services regulatory structure. Over the years, many proposals had been
made to change the U.S. regulatory structure. Many of the proposals,
including one we made in 1996, have concerned reducing the number of
federal bank regulators. Suggestions have also been made to combine SEC
and CFTC, and to consolidate the securities SRO structure. In addition,
proposals for an optional federal charter for insurance companies are
currently being considered. Finally, some proposals for consolidating
across sectors were made in the discussions leading up to the passage
of GLBA, and that law did not end calls for regulatory restructuring
across sectors.
GLBA Permitted Affiliations across Areas without Changing the
Regulatory Structure:
While GLBA removed many of the barriers that had restricted firms from
engaging in banking, securities, and insurance activities, thus
allowing many financial services firms to offer a wider array of
services, it did not change the regulatory structure. By allowing
banking organizations, securities firms, and insurance companies to
affiliate with each other through a financial holding company
structure, GLBA addressed several regulatory developments that had
already permitted the affiliation of depository institutions with
providers of nonbanking financial services. In 1998, the Federal
Reserve had permitted Citicorp, at the time the largest bank holding
company in the United States, to become affiliated with Travelers
Group, a diversified financial services firm engaged in insurance and
securities activities.[Footnote 42] Without the adoption of GLBA, the
combined entity would have been subject to a requirement to divest or
otherwise restructure many of its securities and insurance activities.
In addition, OCC had promulgated regulations permitting national bank
subsidiaries to engage in activities that were not permissible for the
banks themselves.[Footnote 43] Moreover, as discussed earlier, most
thrift holding companies were not subject to activities restrictions.
GLBA codified regulatory developments that had already allowed expanded
services within a holding company or from a national bank subsidiary.
After GLBA, banking, securities, and insurance activities continued for
the most part to be regulated by the same primary federal regulator
that had regulated them when only separate firms could participate in
each activity. For instance, SEC primarily regulates securities
activities regardless of where they occur within a financial holding
company structure.[Footnote 44] Similarly, states continue to be
responsible for regulation of insurance underwriting and other
insurance-related activities undertaken by insurance
companies.[Footnote 45] However, because the blurring of distinctions
that once separated the financial products and services of banks,
securities firms, and insurances companies also could blur the
regulatory responsibilities of their respective regulators, GLBA
contains provisions designed to enhance regulatory consultation and
coordination. For example, with respect to insurance activities by
insurance companies that are part of a financial holding company, the
act calls for consultation, coordination, and information sharing among
federal financial regulators and state insurance regulators.[Footnote
46] In addition, although GLBA established the Federal Reserve as the
umbrella regulator of financial holding companies, the act requires the
Federal Reserve generally to coordinate with and defer to the
"functional" regulators with respect to the institutions they
regulate.[Footnote 47] Federal Reserve supervision of holding companies
is to focus primarily on the consolidated risk position of the entire
holding company, the risks the holding company system may pose to the
safety and soundness of any of its depository institution subsidiaries,
and compliance with consumer protection laws it is charged with
enforcing.[Footnote 48] GLBA also retained OTS responsibility for
supervising thrift holding companies, although it did limit the ability
of nonfinancial companies to obtain thrift charters after May 4, 1999.
In addition to establishing the scheme for the regulation of
consolidated financial organizations involving a bank or thrift, GLBA
provided for a program allowing for consolidated supervision by the SEC
of investment bank holding companies.
One area for which GLBA discussed a potential new regulatory agency was
insurance. As an incentive for states to modernize and achieve
uniformity in insurance regulation, GLBA provided for a federal
licensing agency, the National Association of Registered Agents and
Brokers, that was to come into existence three years after the
enactment of GLBA, if a majority of states failed to enact legislation
for state uniformity or reciprocity.[Footnote 49] However, that agency
has not come into existence because a majority of the states adopted
the types of laws and regulations called for in the section.
Since 1990, Various Proposals Have Sought to Simplify the Bank
Regulatory Structure and Reduce the Number of Regulators:
According to FDIC, many regulatory restructuring proposals concerned
the restructuring of the multiagency system for federal oversight of
banking institutions in the United States have been made since the
1930s, when federal deposit insurance was introduced. Since 1990
several additional proposals have been made, including the following
three made between 1993 and 1994:
* 1994 Treasury proposal.[Footnote 50] This proposal would have
realigned the federal banking agencies by core policy functions--that
is, bank supervision and regulation function, central bank function,
and deposit insurance function. Generally, this proposal would have
combined OCC, OTS, and certain functions of the Federal Reserve and
FDIC into a new independent agency, the Federal Banking Commission,
that would have been responsible for bank supervision and regulation.
FDIC would have continued to be responsible for administering federal
deposit insurance, and the Federal Reserve would have retained central
bank responsibilities for monetary policy, liquidity lending, and the
payments system. Although FDIC and the Federal Reserve would have lost
most bank supervisory rule-making powers, each would have been allowed
access to all information of the new agency as well as limited
secondary or backup enforcement authority. In addition, the Federal
Reserve would be authorized to examine a cross section of large and
small banking organizations jointly with the new agency. FDIC would
have continued to oversee activities of state banks and thrifts that
could pose risks to the insurance funds and to resolve failures of
insured banks.
* H.R. 1227 (1993).[Footnote 51] This proposal would have consolidated
OCC and OTS in an independent Federal Bank Agency and aligned
responsibilities among the new and the other existing agencies. It also
would have reduced the multiplicity of regulators to which a single
banking organization could be subject, while avoiding the concentration
of regulatory power of a single federal agency. The role of the Federal
Financial Institution Examination Council would have been strengthened;
it would have seen to the uniformity of examinations, regulation, and
supervision among the three remaining supervisors. According to a
Congressional Research Service (CRS) analysis, this proposal would have
put the Federal Reserve in charge of more than 40 percent of banking
organization assets, with the rest divided between the new agency and a
reorganized FDIC.[Footnote 52]
* 1994 LaWare proposal.[Footnote 53] The LaWare proposal was outlined
in congressional testimony, but never presented as a formal legislative
proposal, according to Federal Reserve officials. It called for a
division of responsibilities defined by charter class and a merging of
OCC and OTS responsibilities. The two primary agencies under the
proposal would have been an independent Federal Banking Commission and
the Federal Reserve, which would have supervised all independent state
banks and all depository institutions in any holding company whose lead
institution was a state-chartered bank. The new agency would have
supervised all independent national banks and thrifts and all
depository institutions in any banking organization whose lead
institution was a national bank or thrift. FDIC would not have examined
financially healthy institutions, but would have been authorized to
join in examination of problem banking institutions. Based on estimates
of assets of commercial banks and thrifts performed by CRS, the LaWare
proposal would have put the new agency in charge of somewhat more
commercial bank assets than the Federal Reserve.
In 1996, we also recommended ways to simplify bank oversight in the
United States in accord with four principles for effective supervision:
* consolidated and comprehensive oversight of entire banking
organizations, with coordinated functional regulation and supervision
of individual components;
* independence from undue political pressure, balanced by appropriate
accountability and adequate congressional oversight;
* consistent rules, consistently applied for similar activities; and:
* enhanced efficiency and as low a regulatory burden as possible
consistent with maintaining safety and soundness.
We recommended consolidating the primary supervisory responsibilities
of OTS, OCC, and FDIC into a new, independent federal banking agency or
commission. This new agency, together with the Federal Reserve, would
be assigned responsibility for consolidated, comprehensive supervision
of those banking organizations under its purview, with appropriate
functional supervision of individual components. We also recommended
that in order to carry out its primary responsibilities effectively,
the Federal Reserve should have direct access to supervisory
information as well as influence over supervisory decision making and
the banking industry. In addition, we recommended that Treasury have
access to supervisory information, including information on the safety
and soundness of banking institutions that could affect the stability
of the financial system. Furthermore, we recommended that under any
restructuring, FDIC should have an explicit backup supervisory
authority to enable it to effectively discharge its responsibility for
protecting the deposit insurance funds. In coordination with other
regulators, such authority should allow FDIC to go into any problem
institution on its own without the prior approval of any other
regulatory agency.
Partly in Response to Market Convergence, Proposals Have Been Made to
Consolidate Securities and Futures Regulators:
Over the years, proposals have been made to consolidate SEC and CFTC,
partly in response to increasing convergence in new financial
instruments and trading strategies of the securities and futures
markets. For instance, according to a 1990 CRS study, futures contracts
based on financial instruments such as stock indexes are used by
securities firms and large institutional investors simultaneously and
are sometimes interchangeable with certain securities products.
However, these transactions are regulated separately by CFTC and SEC.
Prior to the passage of the Commodity Futures Modernization Act (CFMA)
in 2000, the two agencies had disagreed on the jurisdiction of certain
derivatives. In addition, new trading strategies involving both
securities and futures transactions that have significant potential
impacts on price movements have called for the need for better
monitoring. Treasury also proposed three options to address these
industry changes: (1) merging SEC and CFTC, (2) giving SEC regulatory
authority over all financial futures, or (3) transferring regulation of
stock index futures from CFTC to SEC.
In 1995, Members of Congress introduced the Markets and Trading
Reorganization and Reform Act, which was intended to improve the
effectiveness and efficiency of financial services regulation by
merging SEC and CFTC. In testimony before the House Committee on
Banking and Financial Services, we presented the major benefits and
risks of merging SEC and CFTC, as well as specific issues related to
this bill, to be considered in merging the two agencies. The
anticipated benefits of a merger would have included reduced regulatory
uncertainty concerning the two agencies' regulatory jurisdictions over
particular financial products, a clarification that would likely have
enhanced market efficiency and innovation. Another potential benefit we
identified was greater ease in conducting international regulatory
negotiations. We also identified some risks involved in such a merger,
including (1) a potential for over-regulation that might have resulted
in decreased market innovation and (2) a potential dominance of one
market and regulatory perspective to the detriment of the other. In
addition, we noted some operational risk that might arise during the
transition to a single government agency, such as differences in
institutional cultures and histories. Finally, we cautioned those
considering the merger about the difficulty of quantifying both
potential benefits and risks, and noted further that a merger might
yield only small budgetary cost savings.
Efforts Have Been Made to Change the SRO Structure for Securities:
In 2002, NASD completed the sale of its subsidiary Nasdaq Stock Market
Inc. (NASDAQ), in recognition of the inherent conflicts of interest
that exist when SROs are both market operators and regulators. These
conflicts had become evident in the mid-1990s when NASD was under
scrutiny for price fixing. Concerns about conflicts of interest and
regulatory inefficiencies also prompted proposals to simplify the SRO
structure for securities. In January 2000, the Securities Industry
Association (SIA) detailed the following three possibilities for
changing the SRO structure.[Footnote 54]
* Hybrid SRO model. Under this model, a single consolidated entity
unaffiliated with any market would have assumed responsibility for
broker-dealer self-regulation and cross-market issues, such as those
related to sales practices, industry admissions, financial
responsibility, and cross-market trading. Individual SROs would have
remained responsible for market-specific rules, such as those related
to listings, governance, and market-specific trading. The majority of
SIA members believed that the hybrid SRO model would reduce member-
related conflicts of interest and SRO inefficiencies. Eliminating
duplicative SRO examinations, in their view, would have reduced
inefficiencies in areas such as rule making, examinations, and
staffing. SEC officials agreed that consolidating member regulation
into one SRO could be an advantage of the hybrid SRO model. They noted
that the industry was moving toward a hybrid model as NASDAQ separated
from NASD and NASD contracted to provide regulatory services to more
SROs.
* Single SRO model. Under this model, a single SRO would have been
vested with responsibility for all regulatory functions currently
performed by the SROs, including market-specific and broker-dealer
regulation. According to SIA, the single SRO model could have
eliminated the conflicts of interest and regulatory inefficiencies
associated with multiple SROs, including those that would remain under
the hybrid SRO model. However, SIA did not endorse this alternative,
primarily because of the risk that self-regulation would have become
too far removed from the functioning of the markets. In May 2002, we
reported that, according to SEC officials, it might not be appropriate
or feasible to give a single SRO responsibility for surveilling all of
the markets, such as NASDAQ and NYSE, which have different rules that
reflect differences in the way trades are executed.[Footnote 55]
* SEC-only model. Under this model, SEC would have assumed all of the
regulatory functions currently performed by SROs. SIA did not endorse
the SEC-only model because doing so would have eliminated self-
regulation of the securities industry, taking with it the expertise
that market participants contribute. SIA also expected the SEC-only
model would have been more expensive and bureaucratic, because
implementing it would have required additional SEC staff and mechanisms
to replace SRO regulatory staff and processes. In addition, according
to SIA's report and SEC, a previous SEC attempt at direct regulation
was not successful, owing to its high cost and low quality (relative to
self-regulation), and this convinced SEC and other market participants
that it was not a feasible regulatory approach.[Footnote 56]
We reported in 2002 that at that time, none of the models appeared to
have the support from market participants that would be needed for
implementation. However, since that time the governance structures of
SROs have been under greater scrutiny.
Proposals Have Been Made for an Optional Federal Insurance Charter:
While proposals to regulate insurance at the federal level have been
made from time to time, since 2000 this idea has been gathering steam.
Several trade associations have made proposals for some federal
regulation of insurance, and bills have been introduced in Congress.
According to a CRS study, two bills introduced in the 107th Congress--
the National Insurance Chartering and Supervision Act and the Insurance
Industry Modernization and Consumer Protection Act--included an
optional federal charter for insurance companies that would be similar
to a national bank charter. The proposals would have required the
creation of a federal insurance regulator. These proposals suggested
creating a new federal agency (similar to OCC and OTS) in Treasury. A
bill introduced in July 2003, the Insurance Consumer Protection Act,
would create a federal commission within the Department of Commerce to
regulate the interstate business of property-casualty and life
insurance and require federal regulation of all interstate insurers. It
thus would pre-empt most current state regulation of insurance.
Generally, these proposals differed in whether a federal charter would
include insurance agencies, brokers, or agents and where a federal
regulator would be housed.
Supporters of an optional federal charter include members of trade
associations that generally represent the interests of larger life and
property-casualty insurers--the American Council of Life Insurers, the
American Bankers Insurance Association, and the American Insurance
Association. These and other supporters have argued that an optional
federal charter had benefited the banking sector by encouraging
competition, regulatory efficiency, and product expansion and would
benefit insurers by (1) removing the disadvantage large insurers have
in competing with other financial service providers because large
insurers have to comply with multiple state insurance standards; (2)
allowing for more innovation among insurers because they would no
longer have to secure product approval from different state regulators;
(3) better representing the industry in federal policy and
international trade negotiations through a single federal regulator;
and (4) allowing consumers to have more product choices and more
uniform protections across states.
Opponents of an optional federal charter, including some smaller life
insurers, property-casualty insurers specializing in local services
such as auto and homeowners insurance, and consumer groups, have argued
that creating a new federal regulator would (1) create competition over
industry charters between the federal regulator and state regulators
and hence cause deterioration in the state regulatory system and
industry regulatory standards; (2) lead to the loss of regulatory
innovation and the testing and emergence of better policies because the
current state system allows for regulatory innovation; and (3) be more
costly than supporting NAIC's current efforts to achieve uniformity in
the state system; and (4) be less responsive to consumer needs.
Proposals Made Before and After GLBA Cut across Functional Areas:
Prior to the passage of GLBA, some proposals to restructure the U.S.
regulatory system concerned regulators across the financial services
sectors. For example, in the early 1990s the Chicago Mercantile
Exchange proposed that all federal financial regulation, including that
of OCC, OTS, FDIC, CFTC, SEC, and certain functions of the Federal
Reserve, be consolidated into "a single cabinet level department within
the executive branch" to, among other things, facilitate regulatory
coordination and allow for equal regulation of similar products,
services and markets. In 1997, a congressional proposal included a
National Financial Services Oversight Committee with representatives
from Treasury, each of the federal bank regulators, SEC, and CFTC that
would, among other things, establish uniform examination and
supervision standards for financial services providers and identify
providers that require "special supervisory attention." Following the
passage in 1999 of GLBA, which did not change the regulatory structure,
calls for regulatory restructuring across sectors continued, including
a recommendation in 2002, by the Chairman of FDIC, for a single bank
regulator, securities regulator, and insurance regulator at the federal
level.
[End of section]
Chapter 4: Regulators Are Adapting Regulatory and Supervisory
Approaches in Response to Industry Changes:
Although the U.S. regulatory structure has not changed in response to
the industry changes we have identified--globalization, consolidation,
conglomeration, and convergence--some U.S. regulators have adapted
their regulatory and supervisory approaches to these changes. Some of
these adaptations, especially those related to large, internationally
active firms, have been made as part of or in response to efforts to
achieve some degree of harmonization across the major industrial
nations and within the EU. Some U.S. regulatory agencies have also made
or considered other changes in response to the industry changes that we
have identified.
New Basel II Structure and EU Requirements Will Likely Affect Oversight
of U.S. Financial Institutions:
As part of the evidence of continuing globalization and increased
complexity of financial institutions, the Basel Committee adopted a new
set of standards (Basel II) in June 2004 that member and nonmember
countries may adopt.[Footnote 57] These Basel II requirements are
designed to address some of the shortcomings of the Basel I standards,
and include supervision and market discipline requirements as well as
standards for minimum capital levels. U.S. bank regulators are in the
process of determining how to apply these standards for large,
internationally active firms. Because the EU is requiring securities
firms and other firms with significant insurance operations operating
in the EU to adopt Basel standards as part of its Action Plan,
international harmonization efforts are also having an impact on other
U.S. regulators that oversee large, internationally active firms.
While U.S. Regulators Applied Basel I Standards to All Banks, They
Propose to Require Only Large, Internationally Active Banks to Adopt
Basel II Standards:
In 1988, the Basel Committee adopted the Basel Accord for international
convergence of capital standards (now referred to as Basel I) to
provide uniform risk-based capital requirements with the objectives of
strengthening the soundness and stability of the international banking
system and diminishing a source of competitive inequality among
international banks. These risk-based capital requirements, which were
available for implementation in the Basel Committee members' countries
between 1990 and 1992, focused on limiting credit risk by requiring
certain firms to hold capital equal to at least 8 percent of the total
value of their risk-weighted on-balance sheet assets and off-balance
sheet items, after adjusting the value of the assets according to
certain rules intended to reflect their relative risk.[Footnote 58]
U.S. bank regulators applied these standards to banks and bank holding
companies. Basel I was amended in 1996 to include capital requirements
for market risks for those banks or bank holding companies with a
certain amount of securities and derivatives trading activity or, if
deemed necessary by the regulator for safety and soundness purposes.
Although Basel I generally is credited with improving the regulatory
capital levels of most banks and reducing competitive inequities among
international banks, it did not fully address changes and risks arising
from increasingly complex financial markets. For instance, Basel I did
not account for the internal credit risk mitigation activities of
large, internationally active banks. Also, the limited number of risk-
weighted categories under Basel I meant that the standards had limited
risk sensitivity. This has, among other outcomes, allowed banks to take
on higher risk assets within each category without having to hold more
capital for regulatory purposes. Moreover, Basel I did not explicitly
account for operational risks, such as poor management or security and
process failures.
Basel II, which is available for implementation in banking
organizations in 2006 or 2007, is intended to address the shortcomings
of Basel I. As illustrated in figure 7, Basel II has three pillars: (1)
minimum capital requirements, (2) supervision of capital adequacy, and
(3) market discipline in the form of increased disclosure.
Figure 7: The Three Pillars of Basel II:
[See PDF for image]
[End of figure]
Under the first pillar of Basel II--the definition of capital--the
treatment of market risk and the minimum capital requirement of 8
percent of risk-weighted assets remain the same as that in Basel I.
With regard to credit and operational risk, however, Basel II allows
firms with sophisticated risk management systems--generally large or
internationally active firms--to use their internal risk assessment
models and techniques to determine the appropriate amount of regulatory
capital, with certain restrictions. These advanced approaches will not
be available for implementation until the end of 2007.
The second pillar of Basel II focuses on supervisory review of and
action in response to banks' capital adequacy. Supervisory review is
expected to capture potential risks, including those that are external
to banks, that are not fully captured under Pillar I and to assess
banks' compliance with minimum standards and disclosure requirements of
the more advanced capital calculation options being used by some firms.
Supervisors are to evaluate banks' assessment, monitoring, and
maintenance of their capital adequacy relative to their risk profile,
including compliance with regulatory capital ratios. Supervisory review
can involve on-site examinations or inspections, off-site review,
discussions with bank management, review of work done by external
auditors, and periodic reporting. Basel II calls for supervisors to
intervene at an early stage to prevent capital from falling below
minimum levels and to require remedial action if capital is not
maintained or restored.
The third pillar of Basel II--market discipline--calls for banks to
disclose information about their risk profile, risk assessment
processes, and adequacy of their capital levels. The rationale is that
a bank's borrowing and capital costs will rise if market participants
perceive a bank to be risky, and banks will thus have an incentive to
refrain from excessive risk taking. Members of the Basel Committee note
that market discipline will become more important once banks are using
their internal models and techniques to make capital decisions.
In recognition that large, internationally active banks pose different
risks and use different risk management techniques than smaller, less
internationally active banks, U.S. regulators are proposing to require
that only a number of large, internationally active institutions comply
with capital standards that are consistent with Basel II. Federal
regulators expect that fewer than 10 large, internationally active
banking organizations will be required to operate under rules
consistent with Basel II by the end of 2007. Under current proposals,
other U.S. banks that satisfy certain requirements will have the option
of implementing the Basel II framework, and federal regulators expect
roughly another 10 large banking organizations to adopt capital
standards consistent with Basel II requirements.
EU Financial Conglomerates Directive Is Requiring Some Securities and
Insurance Firms to Have Consolidated Supervision and Apply Basel
Capital Standards:
Certain directives in the EU Action Plan, especially the Financial
Conglomerates Directive, will impact some internationally active firms
in the United States, especially those that have not been subject to
bank or financial holding company oversight by the Federal Reserve
because they do not own commercial banks. In recognition of the risks
posed by financial conglomerates and other financial firms that do not
have consolidated supervision, the directive specifies minimum
requirements for consolidated supervision of such firms conducting
business in the EU. The directive defines a financial conglomerate as a
firm with insurance operations that also engages in banking or
securities activities. In addition, the directive requires that non-
European conglomerates, banks, and securities firms have adequate
consolidated supervision, which would generally include application of
Basel standards.[Footnote 59] Under the directive, which goes into
effect at the beginning of 2005, a non-European financial conglomerate
or group that has a banking presence in the EU that is not considered
to be supervised on a consolidated basis by an equivalent home country
supervisor would be subject to additional requirements by EU
regulators, which could include additional direct supervision.
U.S. regulators that provide or might provide consolidated oversight--
the Federal Reserve, OTS, and SEC, among others--responded to EU
requests for information about their activities as holding company
supervisors. This information was used to develop EU guidance for EU
country regulators in determining whether U.S. firms doing business in
EU countries have consolidated supervision that is equivalent to that
required to be in place in EU host countries. According to EU
officials, specific regulators in EU countries will use this guidance
to determine whether a specific U.S. company operating in Europe has
adequate consolidated supervision.
Officials at the Federal Reserve say that they do not expect to have to
make any changes in the way they oversee bank or financial holding
companies to be deemed an equivalent home country supervisor for
affected companies under their supervision. However, because U.S.
securities firms that are not owned by a bank or financial holding
company are currently not supervised on a consolidated basis the way
bank and financial holding companies are,to comply with the directive,
these securities firms that conduct business in the EU will need to
have a consolidated supervisor sometime in 2005.[Footnote 60] Some of
these firms requested that SEC develop a program to provide them with
consolidated supervision, and SEC responded with its CSE proposal.
Firms opting to become CSEs will be subject to capital requirements
that are consistent with Basel standards,[Footnote 61] which are
described by the rules governing CSEs as an alternative to the net
capital requirements generally required for broker dealers.[Footnote
62] Because the requirements of Basel II were not established with U.S.
securities firms in mind, SEC staff notes that it is participating in a
joint working group established by IOSCO and the Basel Committee to
address issues relating to the treatment of positions held in the
trading book. One issue of interest to holding companies with broker-
dealer subsidiaries is the development of a more risk-based approach to
capital requirements for securities activities. For example, since the
Basel II standards were developed with the expectation of long-term
credit exposures that are common for banks, securities firms believe
that credit risk in their trading books that have much shorter
exposures is overstated using Basel II requirements. IOSCO and the
Basel Committee have had several meetings to discuss this and other
issues.
With regard to required examination and disclosure requirements at the
consolidated level, SEC says it expects to better monitor the financial
condition, risk management, and activities of a broker-dealer's
affiliates that could impair the financial and operational stability of
the broker-dealer or CSE.SEC will examine regulated affiliates of CSE's
that do not have a principal U.S. regulator, but will defer to the UK-
FSA (or another EU regulator) to examine affiliates in EU countries.
For the ultimate holding company, SEC will examine the holding company
unless it determines that it is already subject to "comprehensive,
consolidated supervision" by another principal regulator. Thus, bank or
financial holding companies generally would be exempt from SEC
examination. In the case of holding companies, SEC believes the
disclosure requirements that are part of Basel II are not consistent
with those required by SEC.[Footnote 63] However, SEC staff said that
they would apply Basel II disclosure standards while working to make
them more consistent. SEC says that data being collected by the Basel
Committee to measure the impact of Basel II will include data from the
large securities firms that will register as CSEs, and this may allow
the standards to better reflect the risks of these firms over time.
In response to the Financial Conglomerates Directive, U.S. and other
firms with insurance and banking operations in the EU will need to
choose a consolidated regulator and comply with Basel II. OTS is
responsible for the consolidated supervision of Thrift Holding
Companies, including a number of firms that are conglomerates under the
EU directive. Some of the largest such firms may choose OTS as their
consolidated supervisor for purposes of the directive. These firms
qualify as thrift holding companies because they own a thrift under the
exemption provided before May 1999 or have obtained a thrift charter
since then. Officials at OTS say that 40 companies with insurance
operations are now thrift holding companies, but not all of these are
operating in EU countries or would be deemed conglomerates. These
companies may not qualify as financial holding companies because they
do not own a commercial bank and the scope of their activities, which
may include commercial enterprises, make doing so impractical.
Furthermore, they may not qualify for SEC oversight because they do not
have a broker-dealer affiliate with a substantial presence in the
securities markets. OTS expects its level of supervisory coordination
with foreign regulators to increase as a result of the EU directive.
U.S. Regulators Have Made or Considered Some Other Changes to Their
Regulatory and Supervisory Approaches in Response to Industry Changes:
Because of the increased size and complexity of some banks, U.S. bank
regulators had adopted risk-focused examination procedures that tailor
reviews to key characteristics of each bank, including its asset size,
products offered, markets in which it competes, and its tolerance for
risk. In recognition of the increased size of the largest banks and the
possibility that shareholders and creditors believe that these banks
are too big for regulators to allow them to fail, regulators have
considered requiring banks to issue subordinated debt as a mechanism to
enhance market discipline of banking institutions. However, regulators
have not adopted this requirement, because evidence of its potential
effectiveness is limited. Bank regulators also have adjusted their
approaches in response to what appears to be heightened concern about
reputational risk. SEC had made some changes related to the increased
size and complexity of securities firms prior to adopting its
consolidated supervision rules in response to the EU financial
conglomerates directive. These changes affected the collection of
information related to risk management from the parents and affiliates
of broker-dealers. While CFTC and state insurance regulators will not
adopt Basel II requirements, they have made other changes that
acknowledge how the industry is changing. CFMA acknowledges the
increasingly global nature of the futures industry and the increasing
importance of new financial products. As a result of property-casualty
failures in the 1980s and recognition of changes in the insurance
industry, NAIC adopted a new Solvency Policy Agenda that included risk-
based capital and the creation of a Financial Analysis Unit that
analyzes the behavior of insurers that operate across state lines.
U.S. Bank Regulators Adopted Risk-Focused Supervision for Large,
Complex Firms and Made or Considered Other Changes:
In response to the development of large, complex banking organizations
with diverse and changing risks and sophisticated risk management
systems, U.S. bank regulators have generally placed greater emphasis on
examining an institution's internal control systems and on the way it
manages and controls its risks, rather than on assessing a bank's
condition at a specific point in time. The federal bank regulators
generally apply risk-focused examinations. We reported in 2000 that
since the mid-1990s, the Federal Reserve and OCC have developed and
refined their on-site examination policies and procedures for large,
complex banks to focus on risk assessments along business lines, which
often cross bank charters within the banking organization.[Footnote 64]
Under the risk-focused approach, Federal Reserve and OCC examiners are
to continually monitor and assess an institution's financial condition
and risk management systems through the review of a variety of
management reports and frequent meetings with key bank officials,
documenting the areas they select for review, including their rationale
for selecting those areas. Federal Reserve officials noted that
detecting fraud remains a difficult task under the risk-focused
approach, but that the approach was designed to detect the areas of a
bank's (or bank holding company's) activities that posed the greatest
risk to the safety and soundness of the institution.
In 2002, FDIC adopted an agreement with OTS, OCC, and the Federal
Reserve that allows FDIC to examine insured depository institutions
that pose a greater than normal risk to the deposit insurance funds.
According to FDIC's annual report, under the agreement FDIC has
assigned dedicated examiners to each of the eight largest insured
banking institutions to monitor their financial condition and risk
management processes and obtain timely information on the potential
risks of these institutions. As FDIC is not the primary regulator of
these institutions, it will rely on supervisory information provided by
the primary regulators. In 2003, FDIC established a Risk Analysis
Center to analyze information generated from the dedicated examiner
program, among other tasks.
One change that has been discussed but not made in response to the
growing size of banks is whether banks should be required to issue
subordinated debt as a market discipline tool. The usual disclosure
requirements for publicly traded companies may not be sufficient for
large banks because shareholders may believe that the banks are too big
for regulators to allow them to fail. Because subordinated creditors
are especially sensitive to risks that a bank may fail, mandatory
issuance of subordinated debt has been proposed as a means of enhancing
market discipline to inhibit risk-taking activities and limit losses to
the insurance funds when excessive risk taking damages a bank.
Requiring banks to issue subordinated debt has been discussed in
relation to the market discipline pillar of Basel II, but no such
requirement appears in the standards adopted in June 2004. Similar
proposals have not been adopted in the United States. GLBA directed the
Federal Reserve and Treasury to study the feasibility of requiring
depository institutions that pose significant systemic risk and their
holding companies to maintain some portion of their capital in the form
of subordinated debt. The Federal Reserve and Treasury supported the
use of subordinated debt as a way of enhancing market discipline but
said that more evidence would be needed to make such a policy
mandatory. According to the report, almost all of the largest banking
organizations had voluntarily issued and had subordinated debt
outstanding in excess of 1 percent of their assets, providing some
degree of direct market discipline and transparency. The Federal
Reserve, OCC, and OTS agreed to continue to use various data and
supervision to evaluate the use of subordinated debt.
U.S. bank regulators are also charged with ensuring that banks comply
with various consumer protection laws and laws concerning money
laundering and corporate governance issues. In addition to safety and
soundness examinations, banks are also subject to examinations that
evaluate their performance in meeting the needs of their communities
under the Community Reinvestment Act and their compliance with anti-
money laundering rules under the Bank Secrecy Act and the USA PATRIOT
Act. The regulatory agencies recently announced new examination
procedures for banks' customer identification programs, for instance;
this program was required under section 326 of the USA PATRIOT
Act.[Footnote 65] Regulators also note that failure to comply with
consumer protection and anti-money laundering laws and regulations can
endanger a bank's safety and soundness because they may affect the
bank's reputation. For example, OCC asserts that predatory lending
practices in national banks could damage the reputations and thus the
safety and soundness of those institutions. Furthermore, recent money
laundering activities at some banks--which could affect the reputation
of those banks--appear to have heightened regulatory efforts to prevent
such activity.
SEC Had Made Changes Related to Size and Complexity of Firms Prior to
Becoming a Consolidated Regulator:
With regard to adopting consolidated regulations for CSEs and SIBHCs,
SEC officials said that what appear to be significant changes in their
regulatory and supervisory approach are merely continuations of
previously ongoing trends that recognized the increased size and
complexity of many securities firms. Further, SEC officials recognize
that because of the size of the parent firms, the sudden failure of a
large securities firm that has broker-dealer affiliates could have a
major impact on markets and investors.
SEC says that in setting capital requirements, it has been concerned
with the safety and soundness of broker-dealers for some time. Since
1975, the net capital rule has required that broker-dealers maintain a
minimum level of net capital sufficient to satisfy all obligations to
customers and other market participants and to provide a cushion of
liquid assets to cover potential credit, market, and other risks. SEC
amended its net capital rule in early 1997 to allow broker-dealers to
use statistical models to calculate required capital charges for
exchange-traded financial instruments to better reflect market risk. In
1999, SEC adopted an optional regulatory framework that includes
alternative net capital requirements for OTC derivatives dealers. Under
this framework, OTC derivatives dealers may be permitted to use
statistical models to calculate capital charges for market risk and to
take alternative charges for credit risk. SEC rules also require firms
to integrate their statistical models into their daily risk management
processes and establish a system of internal controls to monitor and
manage the risks associated with their business activities, including
market, credit, leverage, liquidity, legal, and operational risks. With
regard to supervision of risk management of securities firms, SEC
officials say that they have long sought more information on the
parents and affiliates of broker-dealers. Since 1992, SEC has collected
risk assessment information from securities firms that own large
broker-dealers. And, beginning in 1999, SEC has held monthly
discussions regarding these risk assessments.
Much of SEC's examination program is related to ensuring that SROs,
broker-dealers, and investment advisers comply with federal securities
laws and rules, including having adequate systems and procedures in
place to ensure compliance. SEC's examination procedures have evolved
over time. In the mid-1990s, SEC's examination office began conducting
fewer full scope examinations, which review all aspects of operations,
and more frequent risk-focused examinations, which focus on specific
areas or issues. We noted in a 2002 report[Footnote 66] that although
SEC officials said they had been able to maintain their examination
schedules and workload with their existing staff levels, some officials
were concerned that the cycle for certain types of reviews could
stretch beyond the planned time frames. In that report, we noted SEC
officials also said that newly implemented rules would add time and
complexity to the reviews. Overall, SEC officials said their
examination office had lost a lot of experienced staff at the junior
level and that new staff requires constant training.
With the corporate governance and accounting scandals that came to
light beginning in 2002 and with the 2003 revelation of market timing
and late trading abuses in mutual funds, SEC has made additional
changes in its compliance exams and developed rules to improve
corporate governance. We have reported that SEC did not identify the
abusive practices in mutual funds for several reasons, including the
inherent difficulty of detecting fraud and the focus of examinations on
operations of mutual funds rather than on trading in the funds
themselves.[Footnote 67] In response to late trading and other abuses
in the mutual fund industry, SEC says that it is reassessing its
supervision of investment companies.
We also reported that anticipating and identifying problems in a timely
manner is a continuing problem for SEC:
One of the challenges SEC faces is being able to anticipate potential
problems and identify the extent to which they exist. Historically,
limited resources have forced the SEC to be largely reactive, focusing
on the most critical events of the day. In this mode, the agency lacked
the institutional structure and capability to systematically anticipate
risks and align agencywide resources against those risks. In an
environment like this, it is perhaps not surprising that SEC was not
able to identify the widespread misconduct and trading abuses in the
mutual fund industry. Increasing SEC's effectiveness would require it
to become more proactive by thinking strategically, identifying and
prioritizing emerging issues, and marshaling resources from across the
organization to answer its most pressing needs.[Footnote 68] SEC is in
the process of staffing a new risk assessment office that may lead to
more proactive risk-based policies in the future.
Futures and Insurance Regulators Have Not Adopted Basel Standards, but
Have Made Changes in Their Regulatory and Supervisory Approaches:
Many of the changes being made in CFTC's regulatory and supervisory
approaches have come as a result of the passage of CFMA in 2000. The
primary goal of that legislation was to address changes in market
conditions such as the introduction of a wider variety of products,
including contracts based on individual stocks. CFMA replaced "one-
size-fits-all" regulation with broad, flexible core
principles.[Footnote 69] Generally, the new rules recognize the speed
with which these markets change by laying out core principles for
participants and markets, rather than by specifying prescriptive
rules.[Footnote 70] For example, a CFTC regulation requires that
certain entities-derivatives transaction execution facilities and
contract markets-provide authorities and the public with trading
information such as trading practices and contract conditions and
prices, and that they enforce rules to minimize conflicts of interest
in the decision making process, but it does not require specific
measures for carrying out the principles.[Footnote 71]
CFTC has also changed its net capital rules for FCMs to better reflect
changes in the commodity business. To modernize capital requirements
for FCMs, CFTC adopted rules in August 2004 that replace the net
capital requirement based on segregated customer funds with minimum
risk-based capital requirements. The new rules attempt to reflect an
FCM's complete exposure to commodity positions carried for both
customers and noncustomers. According to CFTC's 2003 annual report, the
rules are expected to ensure that a firm's capital requirement reflects
the risks of the futures and options positions it carries.
In addition to the self-regulatory programs administered by the
exchanges and NFA, CFTC oversees the compliance activities of SROs
through audits and financial surveillance to ensure that SRO member
firms are properly capitalized, maintain appropriate risk management
capabilities, and segregate customer funds. According to CFTC's 2003
annual report, to meet CFMA objectives, in the early 2000s CFTC
modified its oversight process for SROs, moving from compliance-based
examinations to risk-focused programs that respond to regulatory core
principles. These exams were to focus on an institution's exposure to,
and internal controls for, managing underlying risks.These programs
were first implemented in 2003 in an SRO oversight examination of the
Chicago Mercantile Exchange covering "financial capacity, customer
protection, risk management, market move surveillance and stress
testing, and operational capability." According to its 2003 annual
report, CFTC is also developing a risk management tool that uses data
received from firm financial filings and large trader reports to
proactively monitor firm risk exposure and assess trader losses from
risky positions that may cause firms to become undercapitalized.
According to an NAIC official, during the mid-to the late 1980s, a high
number of failures among property-casualty insurers as well as a
collective recognition on the part of the insurance regulatory
community that the industry was becoming more complex, in part, because
of technological advances, globalization, and capital market
innovations, led NAIC to adopt its Solvency Policy Agenda. The agenda
was composed of a number of initiatives, including risk-based capital
and the Financial Analysis Unit.
According to NAIC, by 1990 a number of states were experimenting with
risk-based capital formulas, and NAIC approved risk-based capital
standards for life insurance companies in 1992 and for property-
casualty insurers in 1993. NAIC developed and recommended that states
adopt the Risk-Based Capital for Insurers Model Act, which gave state
insurance regulators the authority to act on the results generated by
the risk-based capital formulas. For life insurers, companies are
required to hold minimum percentages of various assets and liabilities
as capital, with these percentages based on the historical variability
of the value of those assets and liabilities. Risk factors are to be
applied, usually as multipliers, to selected assets, liabilities, or
other specific company financial data to establish the minimum capital
needed to bear the risk arising from that item (similar to risk-weights
in banking).In addition, the risk-based capital formula requires the
performance of sensitivity tests to indicate how sensitive the formula
is to changes in certain risk factors.
NAIC's Solvency Policy Agenda also led to the setting up of the
Financial Analysis Unit. This unit's mission is to assist insurance
regulators in achieving their objective of identifying, at the earliest
possible stage, insurance companies that may be financially troubled.
In pursuit of this mission, the Unit performs financial analysis of
insurance companies under the direction of an NAIC working group. The
working group was formed to identify nationally significant insurance
companies--large firms or firms operating in a number of states--that
are, or may become, financially troubled, and to determine whether
appropriate regulatory action is being taken with regard to these
firms.
[End of section]
Chapter 5: Regulators Communicate and Coordinate in Multiple Ways, but
Concerns Remain:
In a system with multiple financial services regulators, communication
and coordination are essential to preventing duplication in agency
oversight, while ensuring that all regulatory areas are effectively
covered. U.S. federal financial services regulators communicate and
coordinate with other federal, state, and foreign regulators within
their sector, and state insurance regulators communicate and coordinate
across states and with insurance regulators in other countries;
however, in each sector concerns remain. To a lesser extent, financial
services regulators communicate and coordinate across sectors with
U.S., state, and foreign regulators, but coordinating regulatory
activities and sharing information continue to be sources of concern.
Agencies have had problems systematically sharing information across
sectors, making it more difficult for regulators to identify potential
crises, fraud, and abuse, and for consumers to identify the relevant
regulators. In addition, regulators do not routinely assess risks that
cross traditional regulatory and industry boundaries.
U.S. Financial Regulators Communicate and Coordinate with Other
Regulators in Their Sectors, but Sometimes Find It Difficult to
Cooperate:
Within each of the four sectors, federal regulators have established
interagency groups to facilitate coordination and also communicate
informally on a variety of issues. Within sectors the federal
regulators generally communicate with each other, with SROs, with
relevant state regulators, and with their international counterparts.
In insurance, NAIC is the primary vehicle for state regulators to
communicate with each other and to coordinate with insurance regulators
in other countries.
Federal Banking Regulators Coordinate Their Activities, but Bank
Failures and International Negotiations Have Been Problematic:
The Financial Institutions Regulatory and Interest Rate Control Act of
1978[Footnote 72] established the Federal Financial Institutions
Examination Council (FFIEC) in 1979 as a vehicle through which bank
regulators could communicate formally. FFIEC is empowered to prescribe
uniform standards and principles and to devise report forms for member
agencies' examinations of financial institutions. FFIEC makes
recommendations to promote uniformity in the supervision of financial
institutions, conducts schools for examiners, and has also established
interagency task forces on consumer compliance, examiner education,
information sharing, supervision, reports, and surveillance systems.
Finally, it serves as a forum for dialogue between federal and state
bank supervisory agencies.
A joint evaluation by the Offices of the Inspector General from three
federal banking regulators found that FFIEC was accomplishing its
legislative mission of prescribing uniform principles, standards, and
report forms.[Footnote 73] Some officials criticized it for not
accomplishing its mission more effectively and taking too long to
complete interagency projects, however. FFIEC is discussing
improvements to its effectiveness by developing annual goals,
objectives, and work priorities. In response to questions about whether
FFIEC should have a broadened role in coordinating banking, insurance,
and securities regulators as a result of GLBA, most officials
interviewed were not in favor of broadening FFIEC to include regulatory
representatives from the insurance and securities industries. Most
officials also did not see the need for a separate coordinating entity
under GLBA modeled after FFIEC. Officials indicated that coordination
under GLBA was occurring as needed and on an ad hoc basis and through
periodic cross-sector meetings hosted by the Federal Reserve. Banking
industry and professional associations said that FFIEC could be more
proactive in communicating with the banking industry, however.
The 1994 Riegle Community Development and Regulatory Improvement Act
mandated improvements to the coordination of examinations and
supervision of institutions that are subject to multiple bank
regulators. A set of basic principles, issued by the regulators in
1993, said that the agencies place a high priority on working together
to identify and reduce the regulatory burden and on coordinating
supervisory activities with each other as well as with state
supervisors, securities and insurance regulators, and foreign
supervisors.[Footnote 74] Their objective is to minimize disruption and
avoid duplicative examination efforts and information requests by:
* coordinating the planning, timing, and scope of examinations and
inspections of federally insured depository institutions and their
holding companies;
* conducting joint interagency examinations or inspections;
* coordinating and conducting joint meetings between bank or bank
holding company management and regulators;
* coordinating information requests; and:
* coordinating enforcement actions.
The Federal Reserve, FDIC, and OCC have additional mechanisms to
communicate and coordinate. Under the Shared National Credit Program,
for example, they jointly review large syndicated loans that involve
several banks to ensure that loans are reviewed consistently and to
reduce regulatory burden on financial institutions. Program reports
also include information on the level of credit risk in banks overall
and by type of bank as well as credit exposures to certain industries.
Similarly, representatives from the agencies meet regularly as the
Interagency Country Exposure Review Committee to jointly determine the
level of risk for credit exposures to various countries.
U.S. bank regulators also communicate regularly with bank regulators in
other countries, both bilaterally and through multicountry
organizations that specialize in bank issues. U.S. bank regulators
overseeing U.S. subsidiaries of foreign banks work with the host-
country regulators in overseeing those institutions. U.S. bank
regulators and UK-FSA explained how they coordinate examinations of
U.K. institutions with U.S. operations such as HSBC and U.S. banks with
U.K. subsidiaries such as MBNA. Similarly, some U.S. regulators
coordinate with BaFin in overseeing Citigroup's activities in Germany
and Deutsche-Bank Securities' activities in the United States. The
Federal Reserve, FDIC, and OCC are members of the Basel
Committee[Footnote 75] and a Federal Reserve Official chaired that
committee during much of the Basel II discussions.
Throughout our meetings with banking agencies, officials told us they
communicate regularly on both a formal and informal basis. They
explained that officials in different agencies, both at the federal and
regional level, know each other well and have each other's personal
cell phone numbers so they can easily contact each other in case of a
crisis. At the regional level, officials and staff from the Federal
Reserve, OCC, FDIC, OTS, and state bank regulatory agencies regularly
meet formally and talk often. Communication across these agencies,
according to several officials, is facilitated by staff often moving
between agencies and by long-standing working relationships.
In some cases, however, interagency cooperation between bank regulators
has been hindered when two or more agencies share responsibility for
supervising a bank. The Superior Bank and the First National Bank of
Keystone (West Virginia) episodes illustrate this problem. Superior
Bank, FSB, a federally chartered savings bank located outside Chicago
failed in 2001. The failure was caused by Superior's strategy of
originating and securitizing large volumes of high-risk loans and the
failure of its management to properly value and account for the
interest that Superior retained in pooled home mortgages. Shortly after
the bank's closure, FDIC projected that the failure of Superior Bank
would result in a substantial loss to the deposit insurance fund. We
found that federal regulators had not identified and acted on the
problems at Superior Bank early enough to prevent a material loss to
the deposit insurance fund. Problems between OTS, Superior's primary
supervisor, and FDIC hindered a coordinated supervisory approach; OTS
refused to let FDIC participate in at least one examination.[Footnote
76] Similarly, disagreements between OCC and FDIC contributed to the
1999 failure of Keystone Bank, which was caused by the bank's
maintaining loans that it did not own on its balance sheet; these
overstated assets were attributed to alleged fraud. FDIC subsequently
announced that it had reached agreement with the other banking
regulators to establish a better process for determining when FDIC will
examine an insured institution where FDIC is not the primary federal
regulator.
Over the last couple of years, bank regulators have expressed differing
views concerning the complex Basel Committee negotiations over Basel II
(see ch. 4). However, it is unclear whether the differing views of the
regulators improved the process, as the regulators claim, or
unnecessarily complicated the process and possibly disadvantaged U.S.
companies, as others have claimed. Bank regulators who sit on the Basel
Committee told us that the outcome of the Basel II negotiations is
better than it would have been with a single U.S. representative
because of the contributions of regulators who represent the
perspectives and expertise of their varied agencies. Regulators note
that they have communicated regularly, but still have the
responsibility of representing their agencies' differing objectives
publicly. U.S. Basel Committee members said that this requirement to
discuss differences in an open and transparent manner, rather than
privately, is a strength of the system. The regulators also noted that
some of the concerns raised by others about the timeliness of U.S.
agencies' involvement in the negotiations might stem primarily from the
long public comment period mandated in U.S. law, rather than the
involvement of multiple agencies. This public comment period, they
noted, would be a requirement even if fewer agencies were involved.
However, the lack of a single contact or negotiating position has
raised questions about these negotiations. Since each of the agencies
on the Basel Committee is charged with representing the objectives of
its agency or the firms it oversees, the negotiations may not represent
the interests of those who are not at the table. For example, OTS--
which oversees some firms that will likely have to comply with Basel
II, due, in part, to the EU Action Plan--does not have a permanent seat
on the Basel Committee. Since the large firms overseen by OTS differ in
some important ways from those overseen by the other agencies, their
positions may not be adequately represented in these negotiations.
However, OTS officials say that they have a temporary seat on the Basel
Committee, while that body considers their request for membership. OTS
also noted that they are active members of two Basel capital
implementation groups. In addition, the sometimes-conflicting views
being expressed by U.S. regulators made it difficult for other
countries to understand our position. Finally, in November 2003 members
of the House Financial Services Committee warned in a letter to the
bank regulatory agencies that the discord surrounding Basel II had
weakened the negotiating position of the United States and resulted in
an agreement that was less than favorable to U.S. financial
institutions.[Footnote 77] H.R. 2042 would establish a committee of
financial regulators chaired by the Secretary of the Treasury to ensure
that there is a unified U.S. position in Basel Committee negotiations.
Federal Securities Regulators Often Communicate and Coordinate
Activities with State Regulators, Securities' SROs, and Foreign
Securities Regulators, but Problems Persist:
Federal securities regulators communicate and coordinate with SROs and
state securities regulators. State securities regulators, including
those in New York and Massachusetts, told us that for the most part
they coordinate enforcement activities with SEC. One difficulty they
pointed to was that privacy issues prevent them from discussing a case
before they are ready to bring charges. However, they note that state
regulators, SEC, and some SROs have jointly pursued securities law
violators.
In addition to overseeing the securities SROs, SEC communicates
regularly with them about various issues. For example, SEC and the SROs
have taken steps to coordinate their examinations. In 2002, we reported
that, according to SEC and SRO officials, representatives of SEC, all
SROs, and the states attend annual summits to discuss examination
coordination, review examination results from the prior year, and
develop plans for coordinating examinations for the coming year. In
addition, regional SEC staff and SRO compliance staff are to meet
quarterly to discuss and plan examination coordination, and SRO
examiners are to meet monthly to plan specific examinations of common
members. At these latter meetings, examiners are expected, among other
things, to collaborate on fieldwork dates, document requests, and
broker-dealer entrance and closeout meetings. SROs also are to share
their prior examination reports before beginning fieldwork. We noted,
however, that SEC officials told us that some broker-dealers that have
tried the coordinated examination program have concluded that it is
more efficient for them to have two separate examinations.[Footnote 78]
Additionally, SEC met with NYSE to discuss registrations of private
foreign issuers.
Securities SROs also communicate regularly with each other. Ten of
them, the major U.S. securities exchanges, are full members of the
Intermarket Surveillance Group (ISG), a group they created in 1983 to
share information across jurisdictions. The purpose of ISG is to share
information and to coordinate and develop procedures designed to assist
in identifying possible fraudulent and manipulative acts and practices
across markets, particularly, between markets that trade the same or
related securities and between markets that trade equity securities and
options on an index in which such securities are included.
Internationally, SEC communicates and coordinates with international
securities regulators through IOSCO and has worked with the EU's CESR
to help harmonize activities between the EU and United States. SEC
staff notes that it is participating in a joint working group
established by IOSCO and the Basel Committee to address issues relating
to the treatment of security positions held in the trading book, which
includes securities held for dealing or proprietary trading. One issue
is the development of a risk-based approach to capital requirements for
securities activities, an issue of interest to holding companies with
broker-dealer subsidiaries. And CESR officials told us that their
communications with SEC have been fruitful in easing certain concerns,
such as those associated with European companies' U.S. operations
having to adopt Sarbanes-Oxley requirements. In May 2004, SEC and CESR
announced their intentions to increase their cooperation and
collaboration aimed at two primary objectives, namely to:
* identify emerging risks in the U.S. and EU securities markets to
address potential regulatory problems at an early stage; and:
* engage in early discussion of potential regulatory projects in the
interest of facilitating converged, or at least compatible, ways of
addressing common issues.
For the rest of 2004 and 2005, SEC and CESR proposed considering issues
related to market structure, mutual fund regulation, accounting
convergence, and credit rating agencies.
Despite efforts of SEC and state securities regulators to communicate
and coordinate their activities, some well-publicized disagreements
developed following the corporate, accounting, and mutual fund
scandals. After a settlement with one of the major U.S. securities
firms concerning the use of research and during investigations of
mutual fund irregularities, SEC and state regulators sometimes
disagreed on what is an appropriate role for each, and on how effective
each has been. For example, the Attorney General of New York,
testifying before Congress concerning analyst conflicts of interest,
said that while the issues had been widely reported in the press for
years, SEC had issued no meaningful new regulations and had taken no
serious enforcement actions prior to New York's investigation. Some
securities industry officials told us that state officials should leave
securities issues to federal officials and noted that unilateral
actions by states have led to differing state securities laws. In
addition, an official at one of the SROs told us that communication
often takes place in a crisis situation, but that there is little or no
time for strategic thinking.
NAIC Is the Coordinating Body for State Insurance Commissioners, but
States Often Pursue Their Own Course:
NAIC is the long-standing structure for communication and coordination
among state insurance commissioners. NAIC's meetings of all state
regulators occur four times a year and interstate working groups meet
regularly in various locations or by teleconference or videoconference
to consider almost every aspect of insurance. Through its development
of model laws such as those concerning risk-based capital standards and
its accreditation program, NAIC has been a mechanism for achieving some
harmonization in state securities regulation. In addition, NAIC
officials and individual state insurance commissioners have coordinated
with insurance regulators from other countries through IAIS and other
forums. IAIS has developed core principles of insurance supervision and
is working on developing a regulatory framework.
Because each state ultimately determines what actions it will take,
NAIC cannot ensure uniform regulation. One tool NAIC has used to
attempt to achieve a consistent state-based system of solvency
regulation throughout the country is its accreditation program.
However, we have reported that the accreditation program has
weaknesses. In our review of the program in 2001, we noted that while
the accreditation program had improved over the 10 years of its
existence, and 47 state insurance departments had been accredited by
NAIC, it still had weaknesses that raised questions about NAIC's
accreditation reviews.[Footnote 79] For example, Mississippi and
Tennessee received accreditation during and after a $200 million theft
that involved four failed insurance companies in those states as well
as two others. In addition, because New York will not adopt the risk-
based capital model law, what is usually considered one of the
strongest state regulatory bodies is not accredited. As a result of
NAIC's inability to force states to adopt certain rules and
regulations, some critics think the voluntary aspect of NAIC reduces it
effectiveness. Other critics argue that because NAIC operates as a
quasi-governmental entity, it exercises too much power over individual
state regulators.
CFTC Coordinates Activities with SROs and Futures Regulators in Other
Countries:
According to CFTC, it coordinates with futures SROs and foreign
financial services regulators. CFTC says it coordinates with exchanges
in monitoring of daily trading activities, looking at the positions of
large traders, and reviewing products listed by exchanges. CFTC's
coordination with futures regulators in other countries--for example,
UK-FSA and BaFin--takes place partially through CFTC's participation in
the activities of IOSCO. CFTC participates in IOSCO working groups on
secondary markets and market intermediaries, enforcement and
information sharing, and investment management. CFTC also participates
on IOSCO task forces covering issues such as implementation of IOSCO
objectives and principles of securities regulation, and payment and
settlement systems. While CFTC participates in working groups and task
forces, it does not have the same status at IOSCO that SEC has; CFTC is
an associate member of that organization, rather than a ordinary
member.
Financial Services Regulators Also Communicate across Financial
Sectors, but Do Not Effectively Identify Some Risks, Fraud, and Abuse
That Cross Sectors:
Federal financial regulators also communicate and coordinate their
activities across "functional" areas. Federal Reserve officials note
that, as directed by GLBA, they rely on information that is shared by
functional regulators, including SEC, in the Federal Reserve's
supervision of bank and financial holding companies. Channels for
communication and coordination have been set up by the regulators or at
the direction of the President or Congress, often in response to a
crisis. However, regulators do not always share information or monitor
risks across sectors.
Federal Reserve Reports That It Relies on Functional Regulators in
Supervision of Bank and Financial Holding Companies:
GLBA directed the Federal Reserve to rely on functional regulators in
its supervision of nonbanking activities in bank and financial holding
companies. For example, broker-dealer subsidiaries of bank or financial
holding companies are subject to oversight by SEC, NASD, and,
potentially, other SROs. In its 2001 strategic plan, the Federal
Reserve reported that it is coordinating with other regulators to
fulfill its role as the holding company supervisor. Federal Reserve
officials told us that this coordination is a key component in their
supervision of bank and financial holding companies, and that
information has been readily provided by functional regulators as part
of that process.
Regulators and SROs Have Created Mechanisms for Communicating across
Sectors:
SEC and CFTC have jointly developed regulations implementing portions
of CFMA that lifted the ban on certain types of securities-based
futures, but the process was difficult. Before CFMA was enacted, SEC
and CFTC competed over regulation of single-stock futures for nearly
two decades. SEC claimed jurisdiction because single-stock futures
behave like the underlying individual stocks and bonds; CFTC claimed
jurisdiction because single-stock futures behave like futures. As a
result of this stalemate, Congress banned the trading of single-stock
futures. CFMA lifted the prohibition on trading single-stock futures
and narrow-based stock index futures and allows these futures to be
traded under a system of joint regulation by SEC and CFTC. However,
according to CFTC and SEC officials, the market for single-stock
futures has been slow to develop. In addition, a CFTC official told us
that it had long had routine, if informal, contacts with SEC concerning
financial integrity and on how certain firm assets and liabilities
should be treated in calculating net capital. SEC staff told us that
they agree with this statement. Similarly, CFTC coordinates its efforts
with SEC on enforcement cases with jurisdiction in several different
geographic areas.
Since its creation in 1983, ISG has expanded to include futures and
foreign exchanges as affiliate members. According to CFTC, the purpose
of ISG today is to provide a framework for the sharing of information
and the coordination of regulatory efforts among exchanges trading
securities and related products to address potential intermarket
manipulation and trading abuses. ISG plays a crucial role in
information sharing among markets that trade securities, options on
securities, security futures products, and futures and options on
broad-based security indexes. ISG also provides a forum for discussing
common regulatory concerns, thus enhancing members' ability to fulfill
efficiently their regulatory responsibilities.
Internationally, regulators from multiple sectors have established
forums to facilitate multinational communication across sectors. The
Joint Forum and FSF are two such forums. The Basel Committee, IOSCO,
and IAIS established the Joint Forum in 1996 to examine cross-sectoral
supervisory issues related to financial conglomerates such as risk
assessment and disclosure. The Federal Reserve, Treasury, and SEC serve
on FSF, which was initiated in 1999 in response to the Asian financial
crisis. FSF brings together, on a regular basis, representatives of
governments, international financial institutions, and others to
promote international financial stability through information exchange
and international cooperation in financial supervision and
surveillance.
Congress and the President Have Directed Regulators to Communicate
across Sectors, Especially after Crises:
By executive order in March 1988, the President established the
President's Working Group on Financial Markets, which is composed of
the heads of the Federal Reserve, SEC, and CFTC and chaired by
Treasury, to address issues related to the 1987 stock market crash. As
we reported in 2000,[Footnote 80] the President's Working Group was
established in response to a crisis and, as the need had arisen, had
continued to function as such. The President's Working Group was
formally reactivated in 1994 and since then has considered several
issues, including the 1997 market decline, hedge funds and excessive
leverage, year 2000 preparedness issues, the rapid growth of the OTC
derivatives market, and threats to critical infrastructure.[Footnote
81] The group meets on a bimonthly basis at the staff level and has
sent letters to Congress with common positions on issues such as energy
derivatives legislation and mutual fund reform.
After the events of September 11, 2001, the President issued an
executive order to create the Financial and Banking Information
Infrastructure Committee (FBIIC), which is charged with coordinating
federal and state financial regulatory efforts to improve the
reliability and security of the U.S. financial system. Chaired by
Treasury's Assistant Secretary for Financial Institutions, FBIIC
includes representatives from federal and state financial regulatory
agencies, including CFTC, the Conference of State Bank Supervisors,
FDIC, the Federal Housing Finance Board, the Federal Reserve, NAIC,
NCUA, OCC, the Office of Cyberspace Security, the Office of Federal
Housing Enterprise Oversight, the Office of Homeland Security, OTS, and
SEC.
In passing GLBA, Congress recognized the need for regulators engaged in
supervising parts of holding companies to communicate and coordinate
across "functional" areas. For example, the Federal Reserve and state
insurance regulators must coordinate efforts to supervise companies
that control both a bank and a company engaged in insurance activities;
similarly, OTS and state insurance regulators have to coordinate
activities as well. The Federal Reserve, FDIC, OCC, and OTS have signed
regulatory cooperation agreements with almost all insurance
jurisdictions; NAIC and the bank regulators say the remainder of the
insurance jurisdictions have state laws that prohibit them from sharing
information. GLBA also established the National Association of
Registered Agents and Brokers, subject to NAIC's oversight, and
stipulated that the association coordinate with NASD in order to ease
the administrative burden on those who are members of both
organizations--that is, agents and brokers that deal both in insurance
and securities.
Other congressionally directed communication includes directing the
Federal Reserve, OCC, and SEC to form an interagency group to draft
guidance on complex structured finance transactions following the
corporate and accounting scandals of the late 1990s. At the invitation
of these agencies, FDIC and OTS joined the interagency group. On May
19, 2004, the agencies issued that guidance for comment. More recently,
Congress has created the Financial Literacy and Education Commission to
coordinate federal efforts and develop a national strategy to promote
financial literacy.[Footnote 82] The commission, which is chaired by
the Secretary of the Treasury, consists of 20 federal agencies,
including all of the federal financial regulators.
In light of the major changes being made in the EU as a result of the
Action Plan as well as other factors, Treasury and EU officials agreed
in early 2002 to establish an informal dialogue on financial market
issues. As part of that dialogue, U.S. and EU financial services
policymakers, including officials from the Federal Reserve and SEC,
meet regularly (1) to foster a mutual understanding of each other's
approach to the regulation of financial markets, (2) to identify any
potential conflicts in approaches as early in the regulatory process as
possible, and (3) to discuss regulatory issues of mutual interest. Some
of the issues that have been considered in the dialogue are Sarbanes-
Oxley, the Financial Conglomerates Directive, accounting standards, and
allowing the placement of foreign electronic trading screens in the
United States absent registration of either the exchange or its listed
securities. As figure 8 shows, regulators and others are talking to
their EU counterparts in a number of separate venues.
Figure 8: United States--EU Regulatory Dialogue:
[See PDF for image]
[End of figure]
Cross-Sector Communication Has Not Facilitated Sharing of Important
Information or Monitoring of Risks:
In evaluating some of the means by which U.S. regulators communicate
across sectors, we have found that these generally do not provide for
the systematic sharing of information, making it more difficult for
regulators to identify potential fraud and abuse, and for consumers to
identify the relevant regulator. In addition, these means do not allow
for a satisfactory assessment of risks that cross traditional
regulatory and industry boundaries and therefore may inhibit the
ability to detect and contain certain financial crises, as can be seen
in the following.
* With regard to the President's Working Group, we reported in 2000
that although it has served as a mechanism to share information during
unfolding crises, its activities generally have not included such
matters as routine surveillance of risks that cross markets or of
sharing information that is specific enough to help identify potential
crises.[Footnote 83]
* In reviewing the near collapse of LTCM--one of the largest U.S. hedge
funds--in 1998, we reported that regulators continued to focus on
individual firms and markets but failed to address interrelationships
across industries. Thus, federal financial regulators did not identify
the extent of weaknesses in bank, securities, and futures firm risk
management practices until after LTCM's near collapse and had not
sufficiently considered the systemic threats that can arise from
unregulated entities.[Footnote 84]
* Our reviews of financial crises showed that almost never did a single
federal financial services regulator have the necessary authority,
jurisdiction, or resources to contain the crisis. Several officials
told us that this dispersion had sometimes limited the federal
government's ability to identify incipient financial crises or to
monitor a crisis once it had occurred.[Footnote 85]
* In reviewing responses to the events of September 11, 2001, we
reported that the multiorganization nature of U.S. financial services
regulation has slowed the development of a strategy that would ensure
continuity of business for financial markets in the event of a
terrorist attack.[Footnote 86]
* In a recent review of interagency communication regarding enforcement
actions taken by the regulatory agencies against individuals and firms,
we reported that while information sharing among financial regulators
is a key defense against fraud and market abuses, the regulators do not
have ready access to all relevant data related to regulatory
enforcement actions taken against individuals or firms. We also
reported that many financial regulators do not share relevant consumer
complaint data among themselves on certain hybrid products such as
variable annuities (products that contain characteristics of both
securities and insurance products) in a routine, systematic fashion,
compounding the problem that consumers may have in identifying the
relevant regulator.[Footnote 87] Determining the relevant regulator for
variable annuities has been a source of regulatory disagreement for
some time. After years of court battles, it was determined that
variable annuities would be regulated as securities by the federal
government but also fall under the authority of state insurance and
securities regulators. At the federal level, SEC regulates the
registration of variable annuity products. Under federal law, variable
annuity products registered with SEC are generally exempt from
registration with state securities regulators. As with other securities
products, NASD regulates the sale of variable annuity products through
broker-dealers. At the state level, the insurance companies that offer
variable annuities generally fall under the jurisdiction of insurance
regulators, though sales of such products can also fall under the
jurisdiction of state securities regulators, or some combination of
both regulators, depending on the state. Some state securities
regulators told us they are making an effort to amend the Uniform
Securities Act to place the oversight of variable annuities sales under
the jurisdiction of state securities departments.
While financial regulators generally supported better sharing of
regulatory information, they cited some barriers to sharing. Those
barriers generally centered on the need for individual agencies to meet
their statutory objectives, including protecting confidential
regulatory information from public disclosure. Officials at one banking
agency, additionally, noted that they are sometimes reluctant to
discuss some issues with SEC because of concern that the discussion
would immediately trigger an investigation, while the banking officials
are working to resolve the issue in a manner that does not compromise
safety and soundness. However, officials at that agency also note that
if the agency becomes aware of a securities law violation, they make an
immediate referral to SEC.
Officials at several of these regulatory agencies noted that their
responsibilities are outlined in law. For example, with regard to
airing differences on Basel II, bank regulators noted that they are
required to put documents out for public comment and respond to those
comments. In other cases, agencies note that they were created as
independent agencies rather than as components of executive agencies
and departments to avoid interfering with these responsibilities.
Officials at one agency, for instance, noted that while Treasury would
have a role in coordinating the efforts of executive agencies prior to
or during international negotiations, their agency would have to ensure
that any such coordinating role did not interfere with their statutory
responsibilities. We have also reported that banking and securities
regulators have said that NAIC's status as a nonregulatory entity was a
barrier to information sharing, even when NAIC was acting on behalf of
its member agencies. In some cases, current state statutes may also
hinder information sharing.
[End of section]
Chapter 6: The U.S. Regulatory System Has Strengths, but Its Structure
May Hinder Effective Regulation:
While structure is not the determining factor in the success of efforts
to provide efficient and effective regulation, it can facilitate or
hinder regulators' efforts. Some U.S. regulators and financial market
participants we spoke with cited the contribution of the current
regulatory structure to the development of U.S. capital markets, and
the U.S. economy overall--for example, for encouraging competition and
promoting stability. However, the regulatory system does not facilitate
the monitoring of risks across firms and markets and does not provide
for a proactive, strategic approach to systemwide issues. In addition,
some outside the U.S. regulatory system, including foreign regulators,
have criticized the U.S. regulatory system for hindering effective
oversight of large, complex firms. We also found that dividing
supervision of large, complex firms among U.S. regulators can result in
inconsistent supervision. In addition, the U.S. regulatory system is
not well structured for dealing with issues in a world where financial
firms and markets operate globally.
While the demarcations between the "functional" areas have blurred and
large firms have diversified across sectors, differences among the
sectors are still important. Thus, the system benefits from having
regulators that specialize in the "functional" areas. However,
"functional" specialization has drawbacks as well, including the
inability to take advantage of economies of scale and scope, the danger
of becoming a voice for certain interests, and the possibility that
firms may seek supervision from the least intrusive regulators.
U.S. Financial Services Regulatory System Has Generally Been Successful
but Lacks Overall Direction:
The U.S regulatory system has allowed financial intermediaries and
markets to contribute broadly to the U.S. economy. Corporations have a
range of financing options to choose from--including bank lending and
securities issuance--that have generally allowed the economy to grow
and consumers have a range of options to choose from that allow them to
make purchases and save for retirement. In addition, new products have
been developed that allow financial institutions to manage risk. Some
of the people we spoke with wondered why anyone would want to change a
regulatory system that has generally supported these aspects of our
economy. Officials at one trade association told us that because our
system is so successful, some other countries are trying to replicate
aspects of it. In addition, at least one academic researcher has
commented that European countries tried to create SEC-type regulatory
agencies where the focus, in part, is on protecting consumers.
U.S. financial institutions are generally characterized as dynamic and
innovative and some aspects of the regulatory system have these
characteristics as well. In chapter 4 of this report, we showed how
some regulatory approaches have evolved over time to better address
changes in the industry. The U.S. financial system is dynamic and
innovative because it is populated by a large number of firms and
different industries that compete with each other in an environment
where no one sector or firm has gained the market power that would
stifle innovation. Similarly, the regulatory system is characterized by
a large number of regulators that must often compete with each other to
provide more innovative or vigilant regulation. Competition among the
banking regulators, especially the Federal Reserve and OCC, is given
credit for changes in regulation including the modernization that
removed prohibitions against securities firms, banks, and insurance
companies operating in a single holding company structure, and
increased regulatory attention to the provision of loans in certain
minority areas. Similarly actions by some state attorneys general and
other securities officials helped prod the Justice Department and SEC
to take more aggressive action and may have helped to highlight a need
for increased resources at SEC.
Having multiple regulators also allows for regulatory experimentation.
An insurance regulator in Illinois can allow the market to set
insurance rates, while insurance regulators in Massachusetts must
approve rate increases. Similarly, for depository institutions, Utah
offers certain advantages to ILCs that obtain charters in that state.
The movement of CFTC to a principles-based approach while SEC stays
with a rules-based approach to regulation is another example of how
regulators can be innovative in experimenting with different approaches
to regulation.
One of the international criteria for a successful regulatory system is
to have adequate resources, and the success of the U.S. regulatory
system is often attributed to the overall quality of U.S. regulators.
Many of the industry officials we talked with felt that their
regulators had the needed skills to provide effective supervision.
Whether the U.S. regulatory structure facilitates the hiring of a
sufficient number of quality staff across all of the regulatory
agencies is an open question. Officials at UK-FSA said they felt they
were better able to attract good staff in a consolidated regulatory
structure because they had better visibility in the marketplace, could
offer better career paths, and in some cases, were able to pay higher
salaries than the agencies that existed before consolidation. However,
that organization still has only about 2,300 staff members. Because
several of the U.S. regulators are this large, have visibility in the
marketplace, and are able to offer competitive salaries, they are well
positioned to hire good staff. However, some of the federal regulators
and state insurance regulatory agencies are relatively small and could
face difficulties in attracting qualified staff due to the substantial
demand by other government agencies and the private sector for the best
personnel.
The regulatory system is also credited with helping to foster financial
stability and maintain continuity. The system has allowed for creative
solutions to potentially destabilizing events. For example, between
January and September 1998, LTCM lost almost 90 percent of its capital.
In September 1998, the Federal Reserve determined that rapid
deterioration of LTCM's trading positions and the related positions of
some other market participants might pose a significant threat to
global financial markets that were already unsettled with Russia's
default on its debt. As a result, the Federal Reserve facilitated a
privately funded recapitalization to prevent LTCM's total
collapse.[Footnote 88] While some experts believe that the market would
have handled this crisis, the Federal Reserve Bank of New York is
credited by many with facilitating the resolution of a major liquidity
crisis with potential systemic repercussions. Again, when the events of
September 11, 2001, led to unsettled government securities trades and
other financial market disruptions, the Federal Reserve provided needed
liquidity to financial markets. Federal bank regulators also provided
guidance to banks on maintaining business relations with their
customers that had been affected by the attacks and issued a joint
statement advising banks that any temporary drops in bank capital would
be evaluated in light of a bank's overall financial condition. SEC took
similar actions to facilitate the successful reopening of stock
markets, including providing temporary relief from some regulatory
requirements.[Footnote 89]
Through its supervision of bank and financial holding companies, the
Federal Reserve does have oversight responsibility for a substantial
share of the financial services industry. The scope of its oversight,
however, is limited to bank and financial holding companies. However,
no government agency is charged with looking at the financial system as
a whole, and the ability of regulators to meet their objectives on an
ongoing basis. We have repeatedly noted that regulators do not share
information or monitor risks across markets or "functional" areas
preventing them from identifying potential systemic crises and limiting
opportunities for fraud and abuse (see ch. 5). In addition, we noted
limitations on effectively planning strategies that cut across
regulatory agencies.
In addition, there is no mechanism for the regulatory agencies to
perform this task cooperatively. From an overall perspective the system
is not proactive, but instead reacts in a piecemeal, ad hoc fashion--
often when there is a crisis. No one has the authority, and there is no
cooperative mechanism to conduct risk analyses, prioritize tasks, or
allocate resources across agencies, although the Office of Management
and Budget may perform some of these tasks for agencies that are funded
by federal appropriations. Similarly, no one has the responsibility,
and there is no cooperative mechanism, for putting together a long run
strategic plan that develops a clearly defined set of objectives for
the financial regulatory system and lays out a plan for achieving those
goals over time.
Each agency does develop its own strategic plan. The Federal Reserve,
for instance, published its most recent plan in December 2001,
providing three primary goals--including promoting "a safe, sound,
competitive, and accessible banking system and stable financial
markets." The plan provided specific objectives and performance
measures, and discussed the external factors that would affect the
Federal Reserve. For instance, it noted the following:
Continued integration of U.S. financial market sectors, accompanied by
the introduction of new financial products and means for their
delivery, is further blurring lines between banks and nonbanks.
Securities firms, insurance companies, financial companies, and even
many prominent industrial companies--as well as commercial banks--are
exploiting technological and financial innovations to seek to capture
larger shares of the financial services market. Industry consolidation
will affect the way the Federal Reserve operates to ensure safety and
soundness and limit systemic risk.
However, no entity is charged with developing a strategic plan like
this that would address how industry changes affect the ability of the
financial regulatory system, as a whole, to meet its many missions.
Structure of U.S. Financial Services Regulatory System May Not
Facilitate Oversight of Large, Complex Firms:
Legal experts and some regulators in EU and Joint Forum countries
believe that large, complex, internationally active firms need to be
supervised on a consolidated level. In response, the EU is requiring
consolidated supervision for certain financial institutions on the
assumption that these firms are so large and so complex that a failure
at anyone of them could pose systemic threats within and across
countries. In addition, many of the countries we studied said that one
of the primary reasons they consolidated their regulatory structure was
to better supervise conglomerates. Historically, in the U.S., holding
company supervision--a form of consolidated supervision--has been
required for companies owning commercial banks and thrifts. These bank
and thrift holding companies were expected to be sources of financial
and managerial strength to their subsidiary banks. They were supervised
to ensure this, and to enforce laws intended to protect the insured
bank even if the parent failed. The goal is to protect the banking
system and, by extension, the deposit insurance fund. Another goal of
this supervision has been to wall off the bank, so that other parts of
the holding company do not benefit from any subsidy inherent in the
provision of deposit insurance or other safety net provision. Holding
company supervision in the United States has evolved to include broader
concerns about the potential systemic risk posed by large financial
services firms.
GLBA continued the U.S. tradition of requiring holding company
supervision when such a company owns a commercial bank or thrift, and
provided for supervision of investment bank holding companies. However,
the structure set up in GLBA has led to concerns about (1) the scope
and effectiveness of the Federal Reserve's authority to examine
functionally regulated entities within a financial holding company, and
(2) the possibility of competitive imbalances among holding company
supervisors. Officials at the Federal Reserve say that because firms
file consolidated financial statements and the Federal Reserve has the
authority to conduct examinations of the holding companies, including
verifying information in the consolidated financial statements, it
generally has the information it needs to oversee bank and financial
holding companies. The officials also said that when the Federal
Reserve has needed information from other regulators, they have been
able to obtain it.
However, some large financial services firms offer insured deposits and
provide a range of banking services without incurring bank holding
company supervision from the Federal Reserve. By owning or obtaining
thrift charters, for instance, some have opted to be thrift holding
companies under OTS supervision. Given the complexity of some of these
parent companies, OTS officials told us they have had to hire staff and
develop expertise needed to understand these companies. We have neither
evaluated OTS's efforts nor compared the depth and coverage of OTS
examinations of large, complex thrift holding companies with that of
Federal Reserve examinations of similarly large, complex bank and
financial holding companies. Other companies have obtained or control
firms with ILC charters, and are not, by virtue of that affiliation,
subject to federal holding company supervision unless the holding
company elects to be a CSE subject to SEC consolidated oversight.
The differential oversight of holding companies in the different
sectors has the potential to create competitive imbalances. In
discussions with some of these companies, we were told they offer
similar services and see themselves as competing more with other large,
internationally active firms in other sectors than with smaller
entities in their own sector. They also raise funds in the same markets
and often participate in the same transactions. Thus, they are taking
on similar risk profiles. However, they may not be subject to the same
supervision and regulation. Bank and financial holding companies are
supervised by the Federal Reserve. Other companies may opt to organize
themselves as thrift holding companies under OTS supervision, and with
SEC's recent CSE and SIBHC rules, some may opt for SEC oversight. While
these differences stem from differences among the supervisory agencies
and their regulatory goals, the differences potentially could have
competitive implications as well. There is no mechanism to ensure that
differences in these regulatory approaches do not create competitive
differences among the different types of holding companies. Further,
under the new CSE rules some firms could be subject to both SEC and OTS
holding company oversight and, as OTS pointed out in its response to
the CSE proposal, perhaps subject to conflicting regulatory
requirements. Finally, there is no mechanism to ensure that any
systemic risk that these large firms might pose would be treated in a
consistent manner.
The regulatory system for consolidated supervision set up under GLBA
rests on the "functional" regulatory system envisioned there--a system
in which "functional" regulators oversee specific activities or
products. Some industry experts believe that this system conflicts with
reality in that it rests, in part, on preserving distinctions between
financial firms based on their lines of business, even though the
differences between financial products and services are blurring and
management of affiliated firms is more efficient and effective when it
is performed centrally, rather than on a firm-by-firm basis. Businesses
say that to benefit from conglomeration, they integrate certain
functions such as risk management and capital allocation. In addition,
new corporate governance standards require that the board and senior
management of a consolidated corporation be responsible for a variety
of conduct-of-business issues throughout the organization. Moreover,
using a brand name or symbol across these legal entities further links
subsidiaries and affiliates in these large, complex firms. Some legal
experts and regulators note that because conglomerates are managed
centrally, regulators that specialize in understanding risks specific
to their "functional" sector may not appreciate complex risks that span
financial sectors and may not understand the risk aggregation
methodologies employed by these firms. Moreover, they note that the
existence of a range of supervisory authorities poses the risk that
financial firms will engage in a form of regulatory arbitrage that
involves the placement of particular financial services or products in
that part of the financial conglomerate in which supervisory oversight
is the least intrusive.
GLBA considers linkages among affiliated firms and contains several
provisions under which regulators are to coordinate and cooperate with
each other to achieve effective and efficient regulation. However, as
we have seen, cooperation among regulators in different sectors is
difficult within a system that values regulatory competition--a feature
of our system that is often credited with making the regulatory system
dynamic and innovative but that may be inefficient as well. As figure 9
shows, the agency overseeing a holding company might have to rely on a
large number of other regulators for information about subsidiaries
engaged in many different functions.
Figure 9: Regulators for a Hypothetical Financial Holding Company:
[See PDF for image]
[End of figure]
Consolidated regulators in the United States also rely on consolidated
financial statements that may include descriptions of risk management
techniques as well. However, these same firms have to create reports
and risk analyses to meet the specific demands of individual
"functional" regulators, particularly when the focus of the regulators
differs from the firm's focus on its consolidated position and risk
management techniques. These reports may have little connection to the
overall risk position of the larger entity.
Regulators say that in certain cases they are not concerned about the
holding company because the entity they supervise is walled off from
the larger entity. For example, several state insurance regulators
noted that the entities they regulate are incorporated and do business
only within their states, although the companies are subsidiaries of
parent companies in other states. Similarly, FDIC notes that the safety
net provided in the form of deposit insurance is only extended to banks
as legal entities. However, it is difficult to imagine that problems in
a significant subsidiary of a conglomerate would not impact the rest of
the organization. Especially when the parts of an organization are
being managed centrally and a company brand name is used across
sectors, the reputation of any part of an organization is likely to
impact the other parts. The problems of its junk bond operations led to
the wider collapse of Drexel Burnham Lambert Group, for instance. Some
observers have noted that when an organization is interconnected in
these ways, it is less likely that a healthy organization would let any
one of its significant parts fail. In addition, Federal Reserve
regulations say that bank holding companies are to be a source of
strength for their bank subsidiaries. Regulators also note that unlike
other countries, the United States still has a large number of small
and medium-sized firms in all of the financial sectors who engage in
activities that are primarily within one sector; however, a research
study issued in 2000 by IMF staff shows that based on a sample of the
top 500 financial services firms in assets worldwide, 73 percent of the
financial assets held by U.S. firms in the sample were held by firms
that engaged in some significant degree in at least two financial
services sectors.[Footnote 90]
Structure of U.S. Financial Services Regulatory System May Not
Facilitate Response to Increased Globalization:
For multinational financial services firms to have effective oversight,
regulators from various countries must coordinate, if not harmonize,
regulation/supervision of financial services across national borders
and must communicate regularly. Many of the companies we spoke with
told us that international harmonization of regulatory requirements
would be good for their businesses. In addition, the degree to which
financial services are integrated across countries makes it essential
for regulators in different countries to communicate regularly. (See
ch. 5.) However, as we have seen in the Basel II discussions and with
the U.S.-EU dialogue, the current U.S. regulatory structure is not
conducive to communicating a single U.S. position in these discussions.
Negotiations related to harmonizing financial regulation across
international borders differ from negotiations related to international
trade, such as those involving the General Agreement on Tariffs and
Trade or the allocation of radio-frequency spectrum.[Footnote 91] In
those negotiations, a structure is in place to develop a unified
negotiating position. And while the outcome of negotiations may not
depend on the number of regulators involved--the relative importance of
U.S. financial institutions, especially in overseas capital markets,
and many other factors are also important--speaking with a single voice
would ensure that the U.S. position is effectively heard.
One area where the mismatch between globalization and the U.S.
regulatory structure is marked is in the area of insurance regulation.
Companies in the insurance industry increasingly operate on a national
and international basis and many companies are foreign-owned, but the
industry is regulated by 55 independent jurisdictions. While insurance
regulators in the United States responded through NAIC to a solvency
crisis in that industry during the early 1990s, the NAIC process
remains cumbersome in a multinational world. Some of the kinds of
problems that can develop as a result of an international industry
being overseen at the state level are evident in the case of Executive
Life. In 1998, issues surrounding the sale of Executive Life, a life
insurer that became insolvent in the early 1990s after investing
heavily in junk bonds, came to light. The issue essentially pitted the
insurance regulator of California against the national government of
France. While this problem was handled within the current structure,
the structure did not facilitate the solution. Not surprisingly,
officials at the EU, UK-FSA, and BaFin told us that having a single
point of contact on insurance issues within the United States would
facilitate international decision making. EU officials noted that
international negotiations with NAIC led to the creation of IAIS;
however, the effectiveness of this organization may be limited by its
inability to speak for the actual insurance regulators in the U.S. In
addition, NAIC's supervisory stance embodied in its model laws differs
from the Solvency II model being created in the EU, especially with
regard to the oversight of insurance groups. NAIC says that IAIS is
developing a model for insurance supervision that conforms to the U.S.
position. Finally, some foreign-based financial services firms that
want to sell insurance products in the United States have characterized
the fragmented U.S. regulatory system as an unfair trade barrier.
Regulators Provide Some Other Benefits by Specializing in Particular
Industry Segments or Geographic Units, but Specialization Has Costs As
Well:
Since there are still significant differences in many areas of the
banking, securities, insurance, and futures businesses, specialized
expertise with knowledge of those businesses is still deemed important.
In addition, state regulators often argue that they have better
knowledge of the needs of consumers in their respective states.
Officials at OTS felt that even though all of the banking regulators
are in the banking sector, OTS is able to focus its skills on the needs
of institutions whose primary asset is mortgages. According to
officials in the futures industry and at CFTC, creating a specialized
regulator for the futures industry has permitted that industry to be
innovative in ways that would not have been possible under either an
SEC or bank regulatory environment. Many of the people we talked with
were concerned about what might happen to these specialized skills and
knowledge if regulators were combined into fewer agencies. In addition,
a few industry representatives in the United Kingdom mentioned the lack
of industry specific skills and knowledge as a concern in the United
Kingdom once the regulator was unified across sectors.
Specialization in a particular industry segment ensures that the issues
of that segment will get considered in larger forums, before Congress,
or in international negotiations. This is particularly evident in the
Basel II negotiations, where FDIC and OTS have expressed the concerns
facing smaller banks--including the possibility that lower capital
requirements for larger banks could place smaller banks at a
competitive disadvantage. The Federal Reserve says that it is
conducting a series of studies looking at the likely impact of Basel
II. After two such studies, they have found no potential negative
effects on smaller banks; however, one study did suggest that larger
banks that do not adopt Basel II could face some competitive
disadvantage. Similarly, OCC expressed the concerns of trust banks over
the capital charges they will have for operational risk.
Of course, specialization can be a double-edged sword that requires
vigilance on the part of the regulator. First, a regulator's
specialization can lead to an inability to track risks that cross
sectors. This inability can be the result of statutory limitations on
the regulator, as well as the regulator's policies and procedures that
reflect its focus on particular risks. Second, if the regulator becomes
too responsive to the needs of the industry, its independence can be in
jeopardy. Again, the Basel II negotiations illustrate the trade-offs.
It is unclear whether regulators who presented the views of particular
segments of the industry were exhibiting their specialized knowledge or
lobbying for the segment of the industry they oversee. One regulator
told us they did not present certain issues earlier in the process
because the regulator had not yet heard from the industry. The chance
for regulators to lose their independence is stronger for agencies that
oversee relatively few entities. An agency is at greater risk of being
"captured" by the industry as consolidation in industry segments
reduces the number of firms being overseen by that regulator.
Alternatively, combining regulators could reduce the impact of any one
segment in decisions, but runs the risk of swallowing up particular
industry segments.
Although having knowledge of a particular industry segment is important
for regulators, other specialized skills and knowledge cut across
regulatory agencies, and these skills and knowledge may not be
efficiently allocated across some of the smaller agencies. All
regulators write rules, conduct off-site monitoring, and examine firms
to determine whether firms are managing their risks effectively and
complying with rules and regulations. In Massachusetts, we found former
Federal Reserve examiners on the staff of OCC and at the Massachusetts
Department of Insurance. In addition, CFTC told us that part of their
implementation of new risk-focused examination procedures includes some
training by Federal Reserve examiners. However, having some relatively
small agencies limits the ability of these agencies to take advantage
of economies of scope and scale relative to these skills. This is
especially true with regard to the specialized skills related to
understanding the complex statistical models that firms are using to
manage risks and the structured products they provide. These skills are
needed in varying degrees by all financial regulatory agencies. Finding
people with the requisite skills is complicated because they are scarce
and in demand by the industry, where the pay is often considerably
higher than at a regulatory agency. Regulators say that consolidating
regulatory agencies would not alleviate this shortage because even if
they added together all of the staff of all of the regulatory agencies
involved in these complex tasks, there would still not be enough staff
with the requisite skills. However, the current system does not provide
a mechanism to ensure that the staff is allocated optimally.
[End of section]
Chapter 7: Congress May Want to Consider Changes to the U.S. Regulatory
Structure:
As we have seen, over the last several decades the financial services
industry has changed in many significant ways. These changes have
blurred the clear-cut boundaries between the "functional" areas
underlying our regulatory structure, so that large firms and products
increasingly compete across or otherwise ignore these boundaries. Very
large firms are increasingly competing in more than one of the four
sectors of the industry and across national boundaries. In addition,
these firms take on similar risks and manage these risks at the
consolidated level. Policies and procedures related to market conduct
and corporate governance also tend to be set centrally in these
organizations. Moreover, hybrid products are blurring the lines between
"functional" activities, and even firms that specialize in a specific
functional area are competing to provide similar services to the same
consumers and businesses.
The financial services industry is critical to the health and vitality
of the U.S. economy. While the industry itself bears primary
responsibility to effectively manage its risks, the importance of the
industry and the nature of those risks have created a need for
government regulation as well. While the specifics of a regulatory
structure, including the number of regulatory agencies and the roles
assigned to each, may not be the critical determinant in whether a
regulatory system is successful, the structure can facilitate or hinder
the attainment of regulatory goals. The skills of the people working in
the regulatory system, the clarity of its objectives, its independence,
and its management systems are critical to the success of financial
regulation.
The U.S. regulatory structure facilitates regulators having detailed
knowledge about banking, insurance, securities, and futures activities,
and these regulators report that they do exchange information relevant
to the supervision of institutions that operate in more than one of
these areas. However, the regulatory structure hinders comprehensively
understanding and, when appropriate, containing the risk-taking
activities of large, complex, internationally active institutions;
promoting the global competitiveness of the U.S. financial services
industry; maintaining to the greatest extent possible competitive
neutrality; and handling possible systemic repercussions. The U.S.
regulatory structure also does not have an ability to develop a
strategic focus that would guide the priorities and activities of each
agency and does not have the ability to allocate resources across
agencies.
Because our regulatory structure relies on having clear-cut boundaries
between the "functional" areas, industry changes that have caused those
boundaries to blur have challenged the regulatory framework. While
diversification across activities and locations may have lowered the
risks being faced by some large, complex, internationally active firms,
understanding and overseeing them has also become a much more complex
undertaking, requiring staff that can evaluate the risk portfolio of
these institutions and their management systems and performance.
Regulators must be able to ensure effective risk management without
needlessly restraining risk taking, which would hinder economic growth.
Similarly, because firms are taking on similar risks across
"functional" areas, to understand the risks of a given institution or
of the system as a whole, regulators need a more complete picture of
the risk portfolio of the financial services industry both in the
United States and abroad. For example, in our report on LTCM and its
rescue, we said the following:
Because of the blurring in recent years of traditional lines that
separate the businesses of banks and securities and futures firms, it
is more important than ever for regulators to assess information that
cuts across these lines. Regulators for each industry have generally
continued to focus on individual firms and markets, the risks they
face, and the soundness of their practices, but they have failed to
address interrelationships across each industry. The risks posed by
LTCM crossed traditional regulatory and industry boundaries, and the
regulators would have needed to coordinate their activities to have had
a chance of identifying these risks. Although regulators have
recommended improvements to information reporting requirements, they
have not recommended ways to better identify risks across markets and
industries.[Footnote 92]
The regulatory framework envisioned in GLBA recognizes some of the
linkages within institutions and contains a framework for consolidated
oversight of some types of firms. Activities at the Basel Committee and
requirements that take affect in early 2005 for firms conducting
business in EU countries have led regulators to adopt some new policies
and rules in this area. However, different regulatory treatment of bank
and financial holding companies, consolidated supervised entities,
supervised investment bank holding companies, and thrift holding
companies may not provide a basis for consistent oversight of their
consolidated risk management strategies, guarantee competitive
neutrality, or contribute to better oversight of systemic risk.
Recognizing that regulators could potentially overcome the impediments
of a fragmented regulatory structure through better communication and
coordination across agencies, Congress has created mechanisms for
coordination and on a number of specific issues directed agencies to
coordinate their activities. In addition, we have repeatedly
recommended that federal regulators improve communication and
coordination. For example, in our report on LTCM, we recommended that
federal financial regulators develop ways to better coordinate
oversight activities that cut across traditional regulatory and
industry boundaries. While we continue to support these
recommendations, we recognize that the sheer number of regulatory
bodies, their underlying competitive nature, and differences in their
regulatory philosophies will continue to make the sharing of
information difficult and true coordination and cooperation in the most
important or most visible areas problematic as well. Therefore,
Congress might want to consider some changes to the U.S. financial
services regulatory structure that address weaknesses and potential
vulnerabilities in our current system, while maintaining its strengths.
However, structural changes themselves will not ensure the attainment
of various regulatory goals. That will require a structure with the
right people and skills, clear regulatory objectives, effective tools,
and appropriate policies and procedures. A different organizational
structure will not necessarily make the inherently difficult task of
detecting fraud in a financial institution easier, and it also would
not ensure more accurate and comprehensive detection. In addition, any
major change in the regulatory structure poses the risk of unintended
consequences and transition costs. Organizational changes may take
place over several years, and regulators might lose sight of their
objectives while management jockeys for control of the agenda of a new
or reformulated regulatory body, staff worry about having jobs in the
new system, or employees become accustomed to their new roles in the
new organization.
Matter for Congressional Consideration:
While maintaining sector expertise and ensuring that financial
institutions comply with the law, Congress may want to consider some
consolidation or modification of the existing regulatory structure to
(1) better address the risks posed by large, complex, internationally
active firms and their consolidated risk management approaches; (2)
promote competition domestically and internationally; and (3) contain
systemic risk. If so, our work has identified several options that
Congress may wish to consider:
* consolidating the regulatory structure within the "functional" areas;
* moving to a regulatory structure based on a regulation by objective
or twin peaks model;
* combining all financial regulators into a single entity; or:
* creating or authorizing a single entity to oversee all large,
complex, internationally active firms, while leaving the rest of the
structure in place.
If Congress does wish to consider these or other options, it may want
to ensure that legislative goals are clearly set out for any changed
regulatory structure and that the agencies affected by any change are
given clear direction on the priorities that should be set for
achieving these goals. In addition, any change in the regulatory
structure would entail changing laws that currently govern financial
services oversight to conform to the new structure.
The first option would be to consolidate the regulatory structure
within "functional" areas--banking, securities, insurance, and
futures--so that at the federal level there would be a primary point of
contact for each. The two major changes to accomplish this at the
federal level would be consolidation of the bank regulators and, if
Congress wishes to provide a federal charter option for insurance, the
creation of an insurance regulatory entity. The bank regulatory
consolidation could be achieved within an existing banking agency or
with the creation of a new agency. In 1996, we recommended that the
number of federal agencies with primary responsibilities for bank
oversight be reduced. However, we noted that in the new structure, FDIC
should have the necessary authority to protect the deposit insurance
fund and that the Federal Reserve and Treasury should continue to be
involved in bank oversight, with access to supervisory information, so
that they could carry out their responsibilities for promoting
financial stability. We have not studied the issue of an optional
federal charter for insurers, but have through the years noted
difficulties with efforts to normalize insurance regulation across
states through the NAIC-based structure. Having a primary federal
entity for each of the functional sectors would likely improve
communications and coordination across sectors because it would reduce
the number of entities that would need to be consulted on any issue.
Similarly, it would provide a central point of communication for issues
within a sector. Fewer bank regulators might reduce the cost of
regulation and the opportunities for regulatory arbitrage, choosing
charters so that transactions have the least amount of oversight. In
addition, issues related to the independence of a regulator from the
firms they oversee with a given kind of charter would be alleviated.
However, consolidating the banking regulators and establishing a
federal insurance regulator would raise concerns as well. While
improved communication and cooperation within sectors would help to
achieve the other objectives outlined above, it would not directly
address many of them. In addition, some constituencies, such as
thrifts, might feel they were not getting proper attention for their
concerns; and opportunities for regulatory experimentation and the
other positive aspects of competition in banking could be reduced.
Further, while this option represents a more evolutionary change than
some of the others, it might still entail some costs associated with
change, including unintended consequences that would undoubtedly erupt
as various banking agencies and their staff jockeyed for position
within the new banking regulator. Similarly, the establishment of a
federal insurance regulator might have unintended consequences for
state regulatory bodies and for insurance firms as well.
Another option would be consolidating the regulatory structure using a
regulation by objective, or twin peaks model. The twin peaks model
would involve setting up one safety and soundness regulatory entity and
one conduct-of-business regulatory entity. The former would oversee
safety and soundness issues for insurers, banks, securities, and
futures activities, while the latter would ensure compliance with the
full range of conduct-of-business issues, including consumer and
investor protection, disclosure, money laundering, and some governance
issues. This could be accomplished by changing the tasks assigned to
existing agencies or by restructuring the agencies or creating new
ones. On the positive side, this option would directly address many of
the regulatory objectives related to larger, more complex institutions,
such as allowing for consolidated supervision, competitive neutrality,
understanding of the linkages within the safety and soundness and
conduct-of-business spheres, and regulatory independence. In addition,
conduct-of-business issues would not become subservient to safety and
soundness issues, as some fear. On the negative side, in addition to
the issues raised by any change in the structure, this structure would
not allow regulators to oversee the linkages between safety and
soundness and conduct-of-business. As reputational risk has become more
important, the linkages between these activities have become more
evident. In addition, if the controls and processes for conduct-of-
business issues and safety and soundness issues are coming from the top
of the organization, they are probably closely related. Finally,
combining regulators into multifunctional units might not allow the
regulatory system to maintain some of the advantages it now has,
including specialized expertise and the benefits of regulatory
competition and experimentation.
The most radical option would combine all financial regulators into a
single entity, similar to UK-FSA. The benefits of the single regulator
are that one body is accountable for all regulatory endeavors. It can
more easily evaluate the linkages within and across firms, including
those between conduct-of-business and safety and soundness
considerations, plan strategically across sectors, and facilitate the
allocation of resources to their highest priority use. However,
achieving these goals would depend on having the right people and
skills, clear regulatory objectives, effective tools, and appropriate
policies and procedures. While the UK-FSA model is intriguing, this
option raises some concerns for the United States. First, because of
the size of the U.S. economy and the number of financial institutions
this entity would have to be very large and, thus, could be unwieldy
and costly. UK-FSA has about 2,300 employees, while estimates of the
number of regulators currently in the United States range from about
30,000 to 40,000. In addition, officials at UK-FSA have commented about
the difficulty of setting priorities when a large number of issues have
to be dealt with. Prioritizing these issues for the United States would
be particularly difficult. Further, an entity with this scope and size
might have difficulty responding to smaller players and might therefore
damage the diversity that has enriched the U.S. financial industry.
Also, staff at such an entity might lose or not develop the specialized
skills needed to understand both large and small companies and risks
that are specific to the different "functional" sectors. And without
careful oversight, such a large and all-powerful entity might not be
accountable to consumers or the industry.
A more evolutionary change would be to have a single entity with
responsibility for the oversight of all large, complex, or
internationally active financial services firms that manage risk
centrally, compete with each other within and across sectors, and, by
their size and presence in a wide range of markets, pose systemic
risks. Having a single regulatory entity for large, complex, or
internationally active firms could be accomplished by giving this
responsibility to an existing regulator or by creating a new entity. A
new entity might consist of a small staff that would rely on the
expertise of staff at existing regulatory agencies to accomplish
supervisory tasks.
Having a single regulatory entity for large, complex, or
internationally active firms would have the advantage of addressing
industry changes, while leaving much of the U.S. regulatory structure
unchanged. A single regulatory entity for large, complex holding
companies would have responsibilities that more closely align with the
businesses' approach to risk than the current regulatory structure. In
addition, this entity could promote competition between these firms by
ensuring, to the greatest extent possible, that oversight is
competitively neutral. A single regulatory entity for internationally
active firms would also be better positioned to help coordinate the
views of the United States in international forums, so that the U.S.
firms are not competitively disadvantaged during negotiations. Finally,
this entity would be better able to appraise the linkages across large,
complex, internationally active firms and, thus, with the aid of the
Federal Reserve and Treasury, could contribute to promoting financial
stability. These potential improvements could be obtained without
losing the advantages afforded by our current specialized regulators,
who would continue to supervise the activities of regulated firms such
as broker-dealers or banks. However, this option also has drawbacks.
While the transition costs might be less than in some of the other
options, the creation of a new entity or changing the role of an
existing regulatory entity would still entail costs and likely some
unintended consequences. It might also be difficult to maintain the
appropriate balance between the interests of the large or
internationally active firms and smaller, more-specialized entities. It
also could involve creating one more regulatory agency in a system that
already has many agencies.
Agency Comments and Our Evaluation:
We received written comments on a draft of this report from the
Chairman of the Board of Governors of the Federal Reserve System, the
Chairman of Federal Deposit Insurance Corporation, the Comptroller of
the Currency, the Director of the Office of Thrift Supervision, and the
Director of SEC's Division of Market Regulation. These letters are
reprinted in appendixes I-V of this report.
In his comments, the Chairman of the Federal Reserve's Board of
Governors said that GLBA provided for a regulatory framework that
struck a balance between the need for regulation and the need for
adaptability. Congress at that time chose to retain and build upon the
functional regulation approach, one that has worked well for the United
States and, as the report notes, has helped promote the competition and
innovation that is a "hallmark" of the U.S. financial system. He
further wrote that, in GLBA, "Congress also reaffirmed its
determination that functional regulation needed to be supplemented by
consolidated supervision of holding companies only in the case of
affiliations involving banks and other insured depository institutions"
because of risks associated with the access that banks and other
insured depository institutions have to the federal safety net. These
risks include the subsidy implicit in the federal safety net being
extended to nonbank affiliates and ownership of an insured bank
reducing market discipline. In addition, he cautioned that if Congress
were to consider restructuring the federal financial regulatory
agencies, it should carefully consider the benefits and costs,
including the effect on the industry's competition and innovation and
that any agency "strategic plan" would be unable to anticipate the
effects of this innovation.
The Chairman of the Federal Deposit Insurance Corporation wrote that
the draft report paid insufficient attention to the fact that deposit
insurance is limited to insured depository institutions, and the danger
that focusing on consolidated supervision would blur the distinction
between the insured depository institution and any uninsured
affiliates. He noted that this distinction would become more important
if the marketplace drives greater mixing of commerce and finance than
currently occurs. He also warned that, if federal financial regulators
were to be consolidated, the value of differing perspectives within the
regulatory system would be lost and independence of the deposit insurer
could be diminished.
The Comptroller of the Currency also warned that any change in the
federal financial regulatory structure "should be approached
judiciously and cautiously." Like the Chairman of the Federal Reserve's
Board of Governors, the Comptroller cautioned that changes in the
federal regulatory structure could diminish the value of the dual
banking system, with both state and federal charters for banks and
thrifts. He noted that, while some foreign regulators may have
preferred the "convenience" of having only one U.S. negotiator in the
Basel II negotiations, this might have been less important than their
desire to reach an agreement without the formal rule-making process
that U.S. regulators must follow.
We agree with many of these comments, and believe the report accurately
reflects the challenges that Congress would face if it were to choose
to consider some consolidation or modification of the current federal
financial regulatory structure. Achieving a balance between market
forces and regulation is an inherently difficult task. We have made
several changes to our report to ensure that it reflects this
difficulty. In particular, we expanded our discussion of the statutory
goals for the federal financial regulators. We also changed phrasing in
the report to make clear that federal deposit insurance does not extend
beyond FDIC-insured depository institutions. It is a valid concern that
deposit insurance not be extended beyond the insured depository under
any circumstances. We have also noted that the federal rule-making
process could contribute to the statements made to us by foreign
financial regulators about U.S. participation in the Basel II
negotiations. In addition, we expanded our discussion of agency
strategic plans to make clear that their purpose is better preparing
agencies to meet the challenges posed by the industry's innovations.
During our study, we were impressed by the strategic focus that appears
to permeate UK-FSA and believe that, in this regard, it is a useful
model for U.S. agencies to study. We agree with the Chairman of the
Federal Reserve's Board of Governors that a single regulator could
"prohibit or restrain" innovation, and believe that the report does
recognize this risk. In addition, while we recognize that Congress
referred to the importance of deposit insurance and of not extending
the safety net in its discussion of the Federal Reserve's role as a
consolidated supervisor, it did not limit its discussion of
consolidated supervision to this purpose and did not ensure that all
insured depositories owned by other entities would be subject to
consolidated supervision. For example, GLBA gave SEC the authority to
oversee SIBHCs--investment bank holding companies that do not own
certain types of insured depositories (at the option of the investment
bank.) In addition, because GLBA exempts some insured depositories,
either directly or as a result of grandfathering some pre-existing
conditions, some of the most complex institutions in the United States
that own insured depositories are not required to have consolidated
supervision. Instead, these institutions are seeking consolidated
supervision because of changes in EU law.
In his comments, the Director of the Office of Thrift Supervision wrote
that the report inadequately recognized OTS's authority over thrift
holding companies, including the top-tier parent company; that the
report inaccurately portrayed OTS's international activities; and
presented an "unbalanced" view in referring to the failure of Superior
Bank, FSB, without referring to other bank failures.
We do not agree. Our report recognizes OTS's authority, noting that,
under the Home Owners' Loan Act and other legislation, "companies that
own or control a savings association are subject to supervision by
OTS." Further, the report includes a section in chapter 1 devoted to a
discussion of OTS's authority to oversee thrift holding companies;
again in chapter 4, we discuss OTS's authority as a consolidated
supervisor. In the report, we acknowledge that because OTS oversees
some of the largest, most complex U.S. financial services firms, it may
serve as the consolidated supervisor for some of these firms under the
Conglomerates Directive of the EU Action Plan. As noted, however, we
have neither evaluated OTS's thrift holding company examinations nor
compared them with Federal Reserve examinations of bank or financial
holding companies of similar size and complexity. Our report also
discusses OTS's role in international forums--specifically its
participation in the Basel II negotiations--and at OTS's suggestion, we
have modified the report to make clear that OTS has applied to be a
permanent member of the Basel Committee. However, we note that they
continue to be the only federal regulator of depository institutions,
other than NCUA, that does not have a permanent seat on this important
committee.
Finally, while Superior Bank failed because of its own actions, the
failure also provided lessons on the need for federal regulators to
work together better. The then-Director of OTS acknowledged this need
in testimony before the Senate Committee on Banking, Housing, and Urban
Affairs.[Footnote 93] In our assessments of that failure, both the FDIC
Inspector General and we found that effective coordination was
lacking.[Footnote 94] We did revise this report to make explicit that
the primary reason for Superior's failure was actions by its owners and
management. We also added a reference to the failure of the First
National Bank of Keystone (West Virginia) that, according to a report
by the Treasury Inspector General, also showed the need for better
communication between FDIC and a primary federal regulator. (In the
Keystone instance, OCC was the primary federal regulator.) Our report
does discuss an agreement among federal bank regulators establishing a
better process to determine when FDIC will join in the examination of
an insured bank. In the comments, OTS also noted that, as a percentage
of assets, the cost to the insurance fund of resolving Superior Bank
was the lowest of the group of failures it cited (including Keystone).
However, the Keystone and Superior failures did incur the largest costs
to the insurance funds ($635 million and $436 million, respectively) of
the failures that OTS cited.
In SEC's comments on the draft report, the Director of the Division of
Market Regulation noted that "supervision and regulation can always be
improved, but the costs of change must always be weighed against its
benefits." As noted above, we concur.
In addition to the written comments, we also received technical
comments and corrections from the staffs at these agencies, or in the
case of OTS as part of their written comments. We have incorporated
these into the report, as appropriate.
We also provided the Department of the Treasury and CFTC with a draft
of the report, so that they could provide written comments, if they
wished. Neither agency chose to provide such comments. Because the
report discusses proposals for an optional federal insurance charter,
we also provided a draft to NAIC, representing the state insurance
regulatory agencies, for them to provide comments; NAIC did not provide
comments. We did receive technical comments and corrections from
Treasury, CFTC, and NAIC staff that we have incorporated into the
report, as appropriate.
[End of section]
Appendixes:
Appendix I: Comments from the Board of Governors of the Federal Reserve
System:
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM:
WASHINGTON, D.C. 20551:
September 16, 2004:
ALAN GREENSPAN:
CHAIRMAN:
Mr. Thomas J. McCool:
Managing Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, N.W., Room 2A32:
Washington, D.C. 20548:
Dear Mr. McCool:
The Federal Reserve appreciates the opportunity to provide comments on
a draft of the GAO's report on the regulatory structure of the U.S.
financial services industry (GAO-04-0889). The report reviews the
existing regulatory structure for the U.S. financial services industry,
as well as the financial services regulatory structure implemented by a
few other countries, and offers some broad alternatives that the
Congress might wish to consider for consolidating the U.S. structure.
These alternatives include vesting a single agency with regulatory
responsibility for the entire financial services industry; establishing
two overarching agencies, with one having responsibility for safety and
soundness regulation and the other for market conduct across all
financial services sectors; vesting a single agency with responsibility
to oversee all large or internationally active financial services
firms; or consolidating the regulatory agencies within individual
sectors.
The report takes on a challenging task, especially given the breadth
and diversity of the financial services industry in the United States
and the fact that, by all indications, our regulatory framework has
worked well and helped promote innovation, competition and stability in
the financial markets. The Congress serves as the "strategic planner"
of the U.S. financial system and in this capacity shapes the overall
structure of our financial regulatory system and balances the costs and
benefits of modifications to that system. Less than five years ago, the
Congress considered the issues of financial modernization,
globalization, concentration and competition across sectors of the
financial services market along with the implication of these forces
for the U.S. regulatory framework in connection with its passage of the
Gramm-Leach-Bliley Act (GLBA). The resulting historic legislation
eliminated outdated restrictions that previously limited the ability of
financial services firms to affiliate and compete with one another and
enhanced the ability of U.S. financial services firms to respond to
technological changes and compete internationally.
GLBA also provided for a regulatory framework that struck a balance
between the need for regulation and the need for adaptability. The
Congress at that time chose to retain and build upon the functional
regulation approach, one which has worked well for the United States
and, as the report notes, has helped promote the competition and
innovation that is a hallmark of the U.S. financial system. Functional
regulation helps ensure that regulatory oversight is imposed in each
sector only to the extent necessary to address perceived market
failings in that sector, such as to provide appropriate protection of
investors (in securities markets) and consumers (in banking markets)
and to ensure the safety and soundness of insured depository
institutions where counterparty discipline is undermined by the effects
of the government subsidy provided to depository institutions through
deposit insurance and access to the discount window and payments
system. Given the variety of goals associated with the regulation of
different components of the financial system, the Congress determined
that supervision was best accomplished by individual functional
regulators who implement statutory mandates tailored to their
individual sectors.
The Congress also reaffirmed its determination that functional
regulation needed to be supplemented by consolidated supervision of
holding companies only in the case of affiliations involving banks and
other insured depository institutions. Notably the Congressional
decision to require consolidated supervision of such financial services
firms was not driven by size, but by the unique risks that occur when
these firms are affiliated with depository institutions that have
access to the federal safety net (that is, the risk that the subsidy
arising from the federal safety net may spread to non-bank affiliates,
as well as the reduced market discipline that may result from the
company's ownership of an insured bank). In retaining the Federal
Reserve's role as the consolidated or umbrella supervisor for bank and
financial holding companies, the Congress reaffirmed the need for the
central bank to maintain a significant role in the supervision of
banking entities. The Federal Reserve, through consolidated capital
requirements, examinations and reporting requirements (supplemented,
where appropriate, by enforcement authority) seeks to ensure that the
risks from the consolidated operations of a bank or financial holding
company--including large and internationally active organizations--do
not pose a risk to its subsidiary depository institutions. Moreover, in
its role as umbrella supervisor, the Federal Reserve works to
coordinate its supervisory functions and share information as
appropriate with the functional regulators of the subsidiaries of a
financial or bank holding company.
On balance, while our present regulatory structure is admittedly
complex, the dynamism of our financial system also owes much to the
opportunities, checks and balances that it provides. This no doubt
helps explain why, less than five years ago, the Congress decided to
build on the existing system of functional regulation when it reviewed
the regulatory system for financial services in connection with the
GLBA. Certainly, if the Congress should decide at some point in the
future to revisit the issue of significant regulatory consolidation, it
should conduct a careful and in-depth analysis of the potential costs
and benefits associated with any proposed changes, including the impact
of any changes on competition and innovation in the financial services
industry.
In particular, the Congress should recognize that it may be difficult
to consolidate the regulators for different sectors without altering
the extent and nature of regulation for at least some sectors of the
industry. Historically, our regulatory system has been guided by the
principle that the best means to promote competition among financial
institutions and to maintain a resilient financial system is to provide
regulation only as needed to address demonstrated market deficiencies.
The long and remarkable history of product innovation in U.S. financial
markets speaks eloquently to the power of this prescription. The
Congress has found functional regulation to be the most desirable
approach to achieve this goal, since it allows the type of regulation
to be tailored to the market short-comings in each sector and allows
individual regulators to focus on the goals mandated by the Congress.
One danger of consolidating the regulatory agencies for different
sectors is that it may lead to the extension of regulation beyond the
individual segments where it currently is focused or to the expansion
of the federal safety net. Spreading the ambit of supervision and
regulation might well increase risk by reducing private market
surveillance and discipline.
Consolidating regulatory responsibility for the entire financial
services industry within a single agency also involves special risks.
No matter how wise the particular regulatory agency, no "strategic
plan" by that agency can adequately foresee innovations in the
industry. Indeed, a single financial regulator with oversight
responsibilities for all sectors of the financial services industry may
well have prohibited or restrained the kinds of innovations and
advances that have contributed so much to the growth and vitality of
the U.S. economy.
If the Congress considers consolidation of the regulatory agencies in
the banking sector, it also should be careful to preserve the "dual"
banking system, which has contributed greatly to competition and
innovation in banking markets.
The Federal Reserve staff has given GAO detailed comments on a draft of
its report to the Congress on regulatory structure. We hope that these
comments have been addressed in the final report.
Sincerely,
Signed by:
Alan Greenspan:
[End of section]
Appendix II: Comments from the Federal Deposit Insurance Corporation:
FEDERAL DEPOSIT INSURANCE CORPORATION,
Washington DC 20429:
DONALD E. POWELL:
CHAIRMAN:
September 14, 2004:
Mr. Thomas J. McCool:
Managing Director:
Financial Markets and Community Investment:
General Accounting Office:
Washington, D.C. 20548:
Dear Mr. McCool:
Thank you for the opportunity to comment on your draft report on the
U.S. financial regulatory structure. Your report recommends that
Congress consider ways to improve the current regulatory structure and
proposes several options as a starting point for those discussions.
The U.S. financial services system is the most vibrant and innovative
in the world. As we explore options for regulatory reform, we should
take care to preserve the strengths that presently underpin our
financial services industry. But the industry is dynamic and what has
served us well in the past may not be sufficient for the many and
profound changes that have occurred in recent history. I have spoken on
several occasions about the need to consider changes to the current
regulatory structure in order to reflect the changes in the industry,
to improve operating efficiencies, and to deliver policy in a timelier
and more consistent manner. In 2003, the Federal Deposit Insurance
Corporation held a symposium on the future of financial regulation,
where some of the questions and issues raised in your report were
explored.
The report is an important contribution to an extensive literature
addressing options for restructuring the U.S. financial regulatory
system. We are concerned, however, that the report did not address
certain significant issues that need to be considered in any discussion
of regulatory structure.
One major concern we have is that the report's treatment of
consolidated supervision does not address the importance of legal-
entity distinctions. In the U.S., significant federal safety net
protections are extended to FDIC-insured depository institutions.
Banks' parents and affiliated organizations do not enjoy similar
protections. Choosing the scope of the federal financial institutions
safety net is one of the most important choices in the financial arena
that Congress can make. Once that choice is made, certain consequences
follow, for with the safety-net protection comes a critical need to
protect against the danger that market discipline will erode, risks
undertaken by the protected entities will increase, and the taxpayers
will be forced to underwrite the cost.
The danger in focusing on consolidated supervision is that the line
delimiting the scope of the federal safety net may become blurred.
Strong supervision and regulation of FDIC-insured depository
institutions at the entity level is necessary to contain the cost of
administering the deposit insurance guarantee. From this perspective it
is imperative that the regulatory structure be designed so that any
additional layers of consolidated or parent company supervision do not
interfere with the ability to regulate and supervise insured
institutions. The more a bank becomes inextricably linked with its
affiliates, the greater the likelihood that problems elsewhere in the
organization will lead to that bank's failure, and the greater the
costs the FDIC will incur in the receivership.
The issue of consolidated versus entity-level supervision will become
increasingly important if, as we expect, the marketplace continues to
evolve toward greater mixing of banking and commerce. The report is
essentially silent on this matter. Will commercial firms that choose to
enter the banking business be subject to consolidated supervision, thus
bringing more and more economic activity into a regulatory framework
designed to administer the financial safety net? Or will we limit our
regulatory attention to the bank itself, the entity that has the direct
connection to the federal safety net, and let the discipline of the
market oversee the nonbank activity?
The tone of the report is generally supportive of some regulatory
consolidation. The FDIC agrees that some degree of regulatory
consolidation would lead to regulatory efficiencies. The current
system, with four federal banking regulators, is complex and
inefficient and occasionally burdensome to the regulated entities.
Indeed, having multiple regulators can too often lead to gridlock on
important policy issues, resource allocation challenges in the presence
of a shifting workload, and operational coordination difficulties.
While correctly noting a number of potential benefits of regulatory
consolidation, the report does not sufficiently address a risk that
could exist under a single regulator model-the loss of effective
independent voices in the regulatory process. A beneficial aspect of
our current regulatory structure is the checks-and-balances that are
built into it. We should consider the experience of countries whose
largest banks dominate their domestic banking markets to a much greater
extent than in the U.S., and where the bank regulatory framework is
more monolithic than in the U.S. In such countries, capital
requirements and capital levels are substantially lower than in the
U.S., and some of those banking systems are experiencing weakness. U.S.
banks are relatively stronger than banks around the world for a number
of reasons, but perhaps especially because bankers, regulators and
Congress learned important lessons in the 1980s and early 1990s. The
lessons were in part embodied in the Federal Deposit Insurance
Corporation Improvement Act and its Prompt Corrective Action framework,
enacted in substantial measure to contain the costs of deposit
insurance. In this regard, we must not lose sight of the importance of
minimum capital requirements for institutions, such as FDIC-insured
banks and thrifts, that enjoy explicit safety-net support.
The need to contain the costs of deposit insurance, and the tools the
FDIC needs to do this, are straightforward and, we believe, necessary
components of any regulatory reform package. First, to fulfill its role
effectively, the deposit insurer needs continued independence and back-
up supervisory authority over the institutions it insures. Along with
that independence, the power to approve or deny applications for
deposit insurance, examine any insured institution or its affiliate,
take enforcement actions, and participate on an ongoing basis in on-
site supervision are vital. While a perfect regulatory framework may
never be attained, a strong and independent deposit insurer can, as
history has shown, serve as an important line of defense against
systemic problems in the industry and, ultimately, losses to the
insurance fund. History also has proven that when an insurer has no
supervisory authority and no input into who receives access to the
federal safety net, the outcome can be costly and even disastrous.
Although your report does not specifically address the importance of a
strong independent insurer with the appropriate authority, the GAO's
historical support for a strong independent insurer indicates that you
share this view.
Finally, we applaud the report for noting the importance of people. The
report mentions how regulatory agencies can essentially rise above a
regulatory framework that is less than ideal, appropriately noting that
"having an adequate number of people with the right skills, clear
objectives, appropriate policies and procedures, and independence are
probably more important" than the regulatory structure. To that end,
the FDIC introduced a legislative proposal on September 1, 2004, that
will, if enacted, enhance the agency's responsiveness to rapidly
changing business and regulatory demands through changes in the size
and composition of the Corporation's employment levels and skill sets.
Thank you again for your efforts. The FDIC looks forward to continued
involvement in discussions of the U.S. regulatory framework.
Sincerely,
Signed by:
Donald E. Powell:
cc: Honorable Wayne Abernathy:
Honorable Thomas J. Curry:
Honorable James E. Gilleran:
Honorable Alan Greenspan:
Honorable John D. Hawke:
Honorable John Reich:
[End of section]
Appendix III: Comments from the Office of the Comptroller of the
Currency:
Comptroller of the Currency:
Administrator of National Banks:
Washington, DC 20219:
September 17, 2004:
Mr. Thomas J. McCool:
Managing Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. McCool:
We have received and reviewed your draft report entitled Financial
Regulation: Industry Changes Prompt Need to Reconsider U.S. Regulatory
Structure. The report was prepared at the request of Congress to
describe the current state of the U.S. financial services regulatory
structure in light of the passage of the 1999 Gramm-Leach-Bliley Act
and increased competition within the financial services industry at
home and abroad. The draft report concludes that (1) the financial
services industry has undergone dramatic changes; (2) some countries
and states have consolidated their regulatory structures, but the
United States has not adopted consolidation proposals; (3) some
regulators are adapting regulatory and supervisory approaches to
industry changes; (4) regulators communicate and coordinate through
multiple venues, but concerns remain; and (5) the U.S. regulatory
system has strengths, but its structure may hinder effective
regulation.
The report offers options for Congress to consider for changing the
regulatory structure to (1) better address the risks posed by large,
complex firms and their consolidated risk management approaches, (2)
promote competition domestically and internationally, and (3) contain
systemic risk. Options for consolidation could take place within
functional areas, by regulatory objective, by combining all regulators
into a single entity, or by creating a single regulator with
responsibility for the oversight of large and/or internationally active
financial services firms that manage risk centrally.
The report will provide a useful reference for continued discussions
and deliberations on this important issue. In particular, the report
underscores two important points with which we agree and that should be
prominent in any dialog on regulatory restructuring. First, no one
regulatory structure or framework is ideal. Each framework has its
strengths and weaknesses and different jurisdictions have adopted
different approaches-most of which remain untested in terms of a
large scale, systemic problem or issue. Second, while any given
regulatory structure may facilitate or hinder the attainment of
regulatory goals, ultimately it is, as your report points out, the
"skills of the people working in the regulatory system, the clarity of
its objectives, its independence, and its management systems that are
critical to the success of financial regulation."
I publicly observed in a speech before the Exchequer Club in April 2003
that the current bank regulatory structure offends many of our
aesthetic and logical instincts. It's complicated; it probably has
inefficiencies; and it takes a great deal of explaining. But, I
concluded that the system works-perhaps not in theory but in
practice. Indeed, it works well. Coordination occurs among the agencies
on a routine basis, with regard to both the supervision of individual
firms and broader supervisory policies and procedures. While there are
examples of inconsistency, such as the recent CRA rulemaking,
regulatory cooperation is the norm, not the exception. On the whole the
agencies have recognized the need to work together to avoid
inconsistencies and to respect one another's jurisdictions and
responsibilities. The exemplary manner in which the agencies cooperated
to prepare for the Year 2000 date conversion and to cope with the
aftermath of the September 11 emergency demonstrate the effectiveness
of the existing relationships.
Another important consideration in deliberating the regulatory
structure is the roles of the Federal Reserve System and the Federal
Deposit Insurance Corporation (FDIC). The Federal Reserve maintains
that it must have a major presence in bank supervision as an adjunct to
its monetary policy and payments system responsibilities. Similarly,
the FDIC opines that it must have a role in bank supervision to
minimize risks and losses to the deposit insurance fund. Adopting the
foreign models described in GAO's report would suggest that bank
supervisory roles be extracted from these entities. Whether such a
dramatic change in a system that is working well overall is warranted,
is debatable.
For example, the GAO's draft report provides the perspective of some
foreign regulators and other parties about the efficacy of the U.S. in
recent Basel II negotiations. While some European regulators may have
preferred the convenience of having only one U.S. regulator at the
"negotiating table," their preference may be more indicative of a
desire to finalize a Basel Accord without regard to the U.S.
deliberative rulemaking process than of a judgment of the value that
all of the U.S. regulators have contributed to the Basel II efforts.
The U.S. agencies have been very clear in the Basel II discussions that
the U.S. will have a rigorous and open rulemaking process. And it is
precisely because of our insistence on this point that important
changes have been made to the Basel II framework so as to not
disadvantage U.S. firms even though this may have resulted in delays to
the Basel Committee's initial timetable.
Finally, it is especially important to weigh the effect of any change
in the regulatory structure at the federal level on the dual banking
system. If the federal bank supervisory agencies were consolidated into
a single independent agency that supervised both federally and state
chartered institutions, then charter choice could become meaningless
and result in pressure for uniformity of powers between state and
federal institutions.
For these reasons, any decision to change or overhaul the U.S.
financial regulatory structure should be approached judiciously and
cautiously.
Thank you for providing us the opportunity to review and comment on the
draft report. Technical suggestions were provided to the analysts
separately.
Sincerely,
Signed by:
John D. Hawke, Jr.:
Comptroller of the Currency:
[End of section]
Appendix IV: Comments from the Office of Thrift Supervision:
Office of Thrift Supervision:
Department of the Treasury:
1700 G Street, N.W.,
Washington, DC 20552
* (202) 906-6590:
James E. Gilleran:
Director:
September 9, 2004:
Thomas J. McCool:
Managing Director, Financial Markets and Community Investment:
United States Government Accountability Office:
441 G Street, NW:
Washington, DC 20548:
Dear Mr. McCool:
This letter provides comments with regard to United States Government
Accountability Office's (GAO) study entitled Financial Regulation:
Industry Changes Prompt Need to Reconsider U.S. Regulatory Structure.
We have carefully considered the findings and recommendations contained
therein, and feel that inferences made throughout the report will
mislead the reader into drawing inaccurate conclusions, not only about
Office of Thrift Supervision's (OTS) regulatory role in supervising
thrift institutions and their holding companies, but the regulatory
framework in the United States (U.S.) and abroad in general. We ask
that you change your report to accommodate our concerns. The following
discussion summarizes particular areas of concern.
1. OTS's Authority as a Consolidated Regulator:
The highlights page that accompanied the draft report asserts that in
the U.S. regulatory structure today, "no one regulator has a complete
picture of complex institutions engaged in more than one functional
area." This statement is not accurate with respect to the thrift
industry. Unique among U.S. Federal banking agencies, OTS has
supervisory authority over the entire thrift holding company structure
up through the top-tier parent company. The origin of OTS's current
authority to supervise thrift holding companies dates to the Savings
and Loan Holding Company Amendments of 1967. Thrift institutions and
their affiliates (including thrift holding companies and their
subsidiaries) are subject to OTS-prescribed regulations and
examinations and are required to give OTS complete access to all books,
records and personnel. Under this authority, we may require reports on
the condition and operations of the thrift institution, its holding
company(ies) and other related entities. OTS may also regulate and
examine independent entities that provide services to thrift
institutions, subsidiaries or affiliates pursuant to 12 U.S.C. 1464(d)
(7). OTS can take enforcement action against the service provider just
as it can against the thrift, subsidiary or affiliate itself.
OTS supervises thrift holding companies that engage in more than one
functional area. More than 100 thrift holding company structures are
engaged in significant lines of business other than banking. These
include insurance, asset management, financial services, retailing and
manufacturing. The following list is representative of the diverse
holding companies OTS supervises and is not all-inclusive. Some
companies are mixed conglomerates with financial and non-financial
operations while others are financial conglomerates. All have an OTS-
licensed thrift, cross-sector and cross-border operations, and are
supervised on a consolidated basis by OTS:
Thrift Holding Company: American International Group;
Consolidated Assets (as of June 2004): $736.0 billion.
Thrift Holding Company: General Electric;
Consolidated Assets (as of June 2004): $697.1 billion.
Thrift Holding Company: General Motors;
Consolidated Assets (as of June 2004): $454.2 billion.
Thrift Holding Company: Lehman Brothers Holdings;
Consolidated Assets (as of June 2004): $346.5 billion.
Thrift Holding Company: American Express Company;
Consolidated Assets (as of June 2004): $179.2 billion.
Thrift Holding Company: The Allstate Insurance Company;
Consolidated Assets (as of June 2004): $139.8 billion.
Thrift Holding Company: Massachusetts Mutual Life Insurance Co;
Consolidated Assets (as of June 2004): $ 89.9 billion.
Thrift Holding Company: Capital One Financial;
Consolidated Assets (as of June 2004): $ 50.1 billion.
Thrift Holding Company: E*Trade Group;
Consolidated Assets (as of June 2004): $ 30.2 billion.
Thrift Holding Company: John Deere;
Consolidated Assets (as of June 2004): $ 26.0 billion.
Thrift Holding Company: Federated Department Stores;
Consolidated Assets (as of June 2004): $ 14.6 billion.
Thrift Holding Company: Auto Club Insurance Association;
Consolidated Assets (as of June 2004): $ 3.1 billion.
Thrift Holding Company: T Rowe Price Group;
Consolidated Assets (as of June 2004): $ 1.7 billion.
[End of table]
OTS is in a unique position of having comprehensive supervisory and
enforcement powers over the entire corporate structure. The Home
Owners' Loan Act clearly enables OTS to obtain a complete picture of
the interrelationships and risks present, regardless of the complexity
of the structure or whether it crosses more than one functional area.
Figures 7 and 10 in the draft report fail to recognize that thrift
holding companies have this level of complexity. Furthermore, the chart
portrayed in Figures 7 and 10 is replete with errors. (For example, the
chart refers to thrifts as "National" as opposed to "Federal."
Furthermore, as crafted, the chart could be construed to imply that a
financial holding company must always control a thrift holding company;
and, most importantly, a holding company structure that controls both a
thrift and a bank is subject to supervision by the Federal Reserve.
OTS would not be involved in holding company supervision in this
example.)
In order to facilitate group-wide supervision, and consistent with the
functional regulation provisions of the Gramm-Leach-Bliley Act (GLBA),
we have entered into regulatory cooperation agreements with supervisors
in the U.S. and abroad. These cooperation agreements generally outline
the type of information to share, procedures for sharing information,
and expectations regarding handling of confidential information. Each
agreement is adapted to address unique circumstances resulting from
different state laws. To date, OTS has executed agreements with 48
state insurance regulators, as well as state banking agencies, state
thrift regulators, the Federal Home Loan Banks, and the National
Association of Securities Dealers (NASD).
OTS also engages in a host of collaborative activities to further
communications and enhance understanding of issues in all financial
sectors. OTS staff has conducted meetings with Securities and Exchange
Commission staff, NASD staff, and state securities regulators to
understand their examination programs and practices so that we may
address any gaps between functional regulators as we conduct our
consolidated review. OTS staff also attends quarterly meetings
sponsored by the National Association of Insurance Commissioners, as
well as cross sector meetings hosted by the Board of Governors of the
Federal Reserve. We have participated in training programs conducted
by the insurance industry, as well as developed training for insurance
supervisors to better understand the banking industry. Furthermore, OTS
staff has been instrumental in bridging the gap between regulators to
understand differences in cross-sector and cross-border banking,
insurance and securities industry practices.
II. OTS International Initiatives:
OTS is extremely concerned with the GAO's inaccurate portrayal of OTS's
international activities. These concerns are two-fold. First, we
believe the report understates OTS's role in international initiatives
on the Basel 11 Capital Framework and the European Union's Financial
Conglomerates Directive. Recognizing that drafts of the Basel II
capital framework and bifurcated capital requirements in the U.S.
failed to address issues unique to mortgage-focused lenders and small
institutions, OTS aggressively started attending and participating in
meetings in Basel. Previously, OTS had informally participated by
providing comments to other U.S. banking agencies that are permanent
members of the Basel Committee. Furthermore, the changes to the Basel
II framework, that some may have perceived as late, substantially
improved the final product. Working together, the U.S. regulators,
including OTS, were successful in negotiating improvements to include:
* The bifurcation of risk into two components--the long-run average
losses (expected losses) and the variability around those losses
(unexpected losses). The U.S. banking agencies took the lead in
developing the appropriate capital treatment for these different types
of losses. This separation of risk into component parts has made the
framework more risk sensitive, especially for such assets as mortgages
and credit cards, which are significant areas of concern to the U.S.
* The appropriate recognition of recovery risk. Periods of high default
rates are often accompanied by low recovery rates on defaulted assets.
The Basel II framework now incorporates recovery risk into the minimum
capital requirement calculation.
* U.S. banks and thrifts make heavy use of securitization structures to
redistribute risk. The U.S. banking agencies have been instrumental in
incorporating the various aspects of securitization into the new
framework.
Without these improvements, the new Basel framework would have been
less risk sensitive and potentially detrimental to certain U.S. banking
interests.
OTS has also been a leader in working with European Union
representatives to implement the Financial Conglomerates Directive
issued in December 2002. In fact, OTS had already implemented a
comprehensive, more formalized supervisory planning process for high
risk or other complex holding companies. For the most part, the
majority of OTS-regulated holding companies that are considered
complex, are identified as such because they either engage in a variety
of financial services or other diverse activities such as commercial,
retail or manufacturing. OTS responded to the convergence of banking,
securities, and/or insurance activities in the thrift industry
significantly before the enactment of GLBA expanded options for banks
and their holding companies.
Our familiarity with these complex structures allowed us to share
experiences not only as a consolidated regulator, but also as a
regulator of structures with a variety of financial and commercial
activities. Preliminary information provided by OTS to colleagues in
the European Union was used as the cornerstone in developing a
questionnaire for determining equivalency status. The legal authority
that OTS has, combined with its' supervisory philosophy and strong
tradition of cooperating with functional regulators across financial
industries, were quickly identified as critical factors in consolidated
supervision. OTS actively employs this tradition with a broader base of
foreign regulators as they become more sensitive to consolidated
supervision. OTS has actively engaged in extensive dialogue with a
variety of foreign regulators, facilitated examination participation,
coordinated numerous meetings, and had countless other communications
on specific cases to deal with issues that arise in internationally
active complex holding companies.
On July 7, 2004, the Banking Advisory Committee for the European Union
issued general guidance on the extent to which the supervisory regime
in the U.S. is likely to meet the objectives of consolidated
supervision. The guidance concluded that there is broad equivalence in
the U.S. supervisory approaches, including that employed by OTS. [NOTE
1]
III. Superior Bank, FSB and Interagency Cooperation:
Throughout the report, the GAO asserts that the failure of Superior
Bank, FSB of Hinsdale, Illinois (Superior), is attributed to poor
interagency cooperation between the Federal Deposit Insurance
Corporation (FDIC) and OTS. The singular focus on Superior's failure in
2001 is unbalanced in light of the fact that there were several other
bank failures around the same time with similar fact patterns. It is
misleading, at best, to elaborate on only one of several similar
failures and conclude without a comparative analysis that if regulatory
cooperation were greater, the failure might not have occurred. In fact,
the FDIC incurred significant losses in the resolution of three other
depository institutions, two of which were regulated at the Federal
level exclusively by the FDIC itself:
Institution: First National Bank of Keystone in Keystone, West
Virginia;
Approximate Cost to Insurance Fund [NOTE 2]: $635 million;
Approximate Cost as a Percentage of Assets: 57%.
Institution: BestBank, Boulder, Colorado;
Approximate Cost to Insurance Fund [NOTE 2]: $172 million;
Approximate Cost as a Percentage of Assets: 55%.
Institution: Pacific Thrift and Loan Company in Woodland Hills,
California;
Approximate Cost to Insurance Fund [NOTE 2]: $52 million;
Approximate Cost as a Percentage of Assets: 44%.
[End of table]
While Superior is the only one in this group discussed in the report,
it did not represent the largest loss to the insurance fund. The cost
to the insurance fund to resolve Superior ($436 million) amounted to 22
percent; the lowest cost of this group as a percentage of assets.
In each of these cases, the FDIC identified characteristics similar to
Superior contributing to the failure of the institutions, including
subprime lending and/or high loan-to-value lending without adequate
prudential standards, apparent fraud, and/or large holdings of retained
interests (or residuals) with questionable value. [NOTE 3] In two of
these failures, there was not another primary Federal regulator to
communicate and coordinate with; yet, the failure still occurred.
These failures occurred not because of an isolated incidence that
could be interpreted as a lack of interagency cooperation, but because
these institutions poorly managed a significant level of asset
securitizations while retaining residual interests that were
overvalued. This is not recognized in the GAO study and, thus, the
references to Superior should be deleted.
IV. Other Corrections:
In addition to the concerns noted above, we note the following
corrections to the report.
Page: Multiple pages;
Clarification/Correction: The report uses the term "bank" both
generically as a depository institution and specifically as a
commercial bank (as opposed to thrift). The dual usage is problematic
to the reader.
Page: 3;
Clarification/Correction: Line 3, after "For banks" add "and state
savings banks." OTS regulates all federal savings associations and
federal savings banks, state savings associations, but not state
savings banks. Similar to state bank charters, the primary regulator
is the state banking department, with FDIC or FRB also providing direct
supervision.
Page: 6;
Clarification/Correction: The first paragraph implies that Basel 11
and consolidated supervision apply beginning January 1, 2005.
Consolidated supervision is effective on that date, but Basel II is not
effective until December 31, 2006, and can be postponed until the end
of 2007 to allow for transition.
Page: 6;
Clarification/Correction: The sentence "These activities may change
the regulation of some. . ." does not make sense.
Page: 6;
Clarification/Correction: The reference on this page, and all other
references to the "Basel Committee on Bank Supervision" should be
changed to "Basel Committee on Banking Supervision."
Page: 7;
Clarification/Correction: Text on this page is based purely on
conjectures (i.e., may hinder, has the potential to create, may limit).
There is not enough emphasis devoted to the current regulatory
structure's contributions to development of U.S. capital markets and
overall economic growth.
Page: 12;
Clarification/Correction: Revise the sentence mid-paragraph that
starts "The Financial Conglomerates Directive requires that non-
European financial conglomerates" (not just banks and security firms).
Page: 12;
Clarification/Correction: On this page, and elsewhere in the document
the term "inappropriately supervised" firm has negative connotations.
Such terminology is not used in the Financial Conglomerates Directive.
The sentence should read as follows: "Under the directive, which goes
into effect at the beginning of 2005, a non-European financial
conglomerate, securities firm, or bank or financial holding company
that is not supervised (delete "considered inappropriately) on a
consolidated basis by an equivalent (delete "in its") home country
supervisor would be subject to additional . . ."
Page: 12;
Clarification/Correction: Same paragraph, the sentence that starts "As
a result many major U.S. companies. ." change "illustrate" to
"demonstrate" and delete "acceptable" before consolidated supervision.
Page: 12;
Clarification/Correction: Same paragraph, next sentence "Those
companies that own thrift institutions may meet the requirement because
OTS oversees thrift holding companies (insert on a consolidated
comprehensive basis)."
Page: 13;
Clarification/Correction: First line, insert the word "investment"
before holding companies.
Page: 13;
Clarification/Correction: Line 13, sentence that begins "Securities
regulators have repeatedly revised. . ." change "had" to "have."
Page: 14;
Clarification/Correction: Line 1, statement that "coordinated
responses are not reached on some major issues." At end of sentence,
add, "however, when there is a divergence, it reflects the need to
address specific issues associated with a particular regulator's
licensees (for example, thrift institutions that are primarily mortgage
lenders, or small institutions)."
Page: 14;
Clarification/Correction: First paragraph, line 7, what does "On the
international front" refer to? Basel 11 negotiations? Other
negotiations? Clarification is needed.
Page: 15;
Clarification/Correction: Paragraph 2, line 2, "some cases" is an
overstatement.
Page: 15;
Clarification/Correction: Paragraph 2, line 9, change "stat" to
"state."
Page: 18;
Clarification/Correction: Line 2, change "communicate" to
"communication."
Page: 18;
Clarification/Correction: Third line from the bottom. It is fallacious
for the GAO to suggest that a "small agency" could be created to
supervise the largest and most complex firms. Extensive resources are
needed to accomplish a mission this expansive.
Page: 19;
Clarification/Correction: Line 8 references footnote 2, there is no
accompanying footnote.
Page: 20;
Clarification/Correction: Line 1 refers to "International Stability
Forum" whereas page 35 refers to "Financial Stability Forum."
Page: 20;
Clarification/Correction: Capitalize "Financial" in footnote 4.
Page: 21;
Clarification/Correction: Footnote 5 runs across three pages, also
reference to percent of domestic deposits held by ILCs is inconsistent
between text (line 8) and footnote 5 age 22).
Page: 26;
Clarification/Correction: Paragraph l, line 1, delete extra "be."
Page: 26;
Clarification/Correction: Middle paragraph, line 3. Add "and thrifts"
after "Banks," and add "or Federal thrifts" after "national banks"
later in the same sentence.
Page: 26;
Clarification/Correction: Second line from bottom, change "thrifts" to
"state savings banks."
Page: 27;
Clarification/Correction: In addition to federally chartered thrifts,
OTS supervises state chartered savings associations.
Page: 27;
Clarification/Correction: Line 6, change "bank regulator" to "federal
regulator."
Page: 27;
Clarification/Correction: Line 13, change to "...regulators oversee
and enforce compliance with consumer. . ."
Page: 27;
Clarification/Correction: Third and fourth lines from the bottom,
delete "was first housed at" and delete the second "Farm Credit
Administration."
Page: 27;
Clarification/Correction: Footnote 9, correct legal cite to read
"Enforcement" not "Enhancement" regarding FIRREA.
Page: 28;
Clarification/Correction: Line 3, change "position's" to "agencies'."
Page: 28;
Clarification/Correction: Footnote 11 ends abruptly. Should "security"
or another word be added after "underlying?"
Page: 29;
Clarification/Correction: Footnote 12, thrifts, as well as national
banks, may engage in the certain types of insurance activities noted.
Page: 30;
Clarification/Correction: Third to last line, reference should be to a
thrift or bank.
Page: 30;
Clarification/Correction: Last line, delete hanging "s" in middle of
line.
Page: 31;
Clarification/Correction: Line 4, change "Bank" to "bank."
Page: 32;
Clarification/Correction: Line 1, change "Owner's" to "Owners' ."
Page: 32;
Clarification/Correction: Line 8, change "an" thrift holding company to
"a"thrift holding company.
Page: 34;
Clarification/Correction: First bullet, line 2, insert "as members"
after "participate." At the end of the sentence after the footnote,
insert "OTS participates as a temporary member pending acceptance of
its request for permanent membership by the Basel Committee." Same
bullet, line 9, delete "foreign" before "bank."
Page: 34;
Clarification/Correction: Footnote 18 is misplaced. It belongs on page
33.
Page: 37;
Clarification/Correction: Footnote 24 missing a period.
Page: 45;
Clarification/Correction: Footnote 26, change "consolidatiob" to
"consolidation."
Page: 49;
Clarification/Correction: Line 3, change "that" to "whether."
Page: 53;
Clarification/Correction: Line 2, change "reduce risk and securitized"
to "reduce risk while securitized."
Page: 53;
Clarification/Correction: Line 5, change "geographic lines and" to
"geographic lines along with." regulators do not routinely assess
risks. . ." [OTS does assess risk.].
Page: 94;
Clarification/Correction: Middle paragraph, line 1, change to include
OTS as follows "The Federal Reserve, FDIC, OCC and OTS. . ."
Page: 94;
Clarification/Correction: Footnote 55 is misplaced. It belongs on page
93.
Page: 95;
Clarification/Correction: Line 5, add "OTS participates as a temporary
member on the Basel Committee while its permanent membership request is
considered by the Committee."
Page: 95;
Clarification/Correction: Footnote 56 is misplaced. It belongs on page
94.
Page: 96;
Clarification/Correction: Line 11, the sentences "For example, OTS" and
"Since the large firms" are not factually correct. Although OTS does
not have a permanent seat as a member of the Basel Committee, we have a
temporary seat on the committee while our membership request is
considered. Also, OTS supervised firms were represented in the
negotiations on Basel II; not only do we attend Basel Committee
meetings, we are also active members on two Basel capital
implementation subgroups.
Page: 96;
Clarification/Correction: Footnote 57 is misplaced. It belongs on page
95.
Page: 98;
Clarification/Correction: Footnote 59 is misplaced. It belongs on page
97.
Page: 104;
Clarification/Correction: Footnote 63 is misplaced. It belongs on page
103.
Page: 106;
Clarification/Correction: Footnote 67 is misplaced. It belongs on page
105.
Page: 108;
Clarification/Correction: Line 14, add "system" after "regulatory." We
also disagree with the sentence "The U.S regulatory system is also not
well structured for dealing with issues in a world where financial
firms and markets operate globally." U.S. supervisors have had no
significant problems in dealing with supervisors around the world, in
banking or other sectors, regarding issues of mutual interest.
Page: 111;
Clarification/Correction: Footnote 68 is misplaced. It belongs on page
110.
Page: 123;
Clarification/Correction: Line 11, change "communicate" to
"communications."
[End of table]
V. Conclusion:
Financial regulators in the U.S. have continually adapted to industry
change with innovative and flexible regulatory and supervisory
strategies. This level of flexibility and responsiveness cannot be
guaranteed in an alternate structure. A healthy tension between the
federal banking regulators has developed as we each bring the unique
perspectives of the industry we supervise and regulate. This has
significantly benefited the U.S. banking system, making it the
healthiest, most innovative and robust in the world. Further, we note
that the regulatory systems of other countries addressed in this report
were restructured in response to significant problems or failing
banking systems. The report's conclusions fail to recognize that this
is not the case in the U.S., and, in fact, as noted by the GAO in the
highlights cover page, the "strength and vitality of the U.S. financial
services industry demonstrates that the regulatory structure has not
failed." The countries studied did not take on change for the sake of
change, nor have their new regulatory structures been tested by a
crisis to determine if they perform as hoped. In fact, in one country
systemic problems have continued to exist, even after the regulatory
system was restructured.
The regulatory consolidation undertaken by the United Kingdom, Germany,
Japan, the Netherlands, and Australia, individually, cannot
realistically be compared due to the much greater size of the U.S.
financial markets and corresponding number of regulators required. To
adjust the scale, the entire European market (not individual countries)
should be compared to the United States market as a whole. One
regulator supervising the entire U.S. financial services industry would
be unresponsive to the complexities of our dynamic and large financial
marketplace. We also do not agree with statements in the draft report
that U.S. firms are competitively disadvantaged by the presence of
multiple regulators during international negotiations. Instead, we
firmly believe that they are more ably represented by regulators that
are attuned to their specific issues.
Finally, we note that one of the matters you highlight for
Congressional consideration is that fewer bank regulators might reduce
the cost of regulation and the opportunities for regulatory arbitrage.
Regardless of how many Federal regulators exist, as long as financial
institutions have the option of a state charter or license, the
opportunity for regulatory arbitrage will continue to exist. We believe
in the dual regulation of financial institutions by state and federal
regulators, and we do not recommend it be abolished.
The caliber of U.S. banking regulation is unparalleled in the world
today and U.S. financial institutions have been operating in recent
years at historically unprecedented levels of profitability and
capitalization; therefore, any major change to the regulatory structure
would be ill-advised. If you have any questions or need additional
follow-up information, please contact Scott M. Albinson at (202)
906-7984.
Sincerely,
Signed by:
James E. Gilleran:
cc: Wayne A. Abernathy, Assistant Secretary for Financial Institutions,
DOT:
Susan Schmidt Bies, Governor, FRB:
Roger W. Ferguson, Jr., Vice Chairman, FRB:
Cynthia A. Glassman, Commissioner, SEC:
John D. Hawke, Comptroller, OCC:
James E. Newsome, Chairman, CFTC:
Donald E. Powell, Chairman, FDIC:
NOTES:
[1] The guidance did note certain caveats with many of the U.S.
financial regulators. In the case of OTS, the only caveat noted was
that because of the diverse population of holding companies we
regulate, we do not employ a rigid, consolidated minimum capital
requirement. The Banking Advisory Committee clearly understood our
thinking behind our case-by-case approach. No other comments were noted
with respect to OTS.
[2] Data from several FDIC Office of Inspector General reports (see
Report Nos. 04-004 and 02-024) and from FDIC update of September 8,
2004.
[3] See Testimony of Donna Tanoue, then Chairman of the Federal Deposit
Insurance Corporation, on recent bank failures and regulatory
initiatives before the Committee on Banking and Financial Services on
February 8, 2000.
[End of section]
Appendix V: Comments from the Securities and Exchange Commission:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION:
WASHINGTON, D.C. 20549:
DIVISION OF MARKET REGULATION:
September 15, 2004:
Mr. Thomas J. McCool:
Managing Director:
Government Accountability Office:
Financial Markets and Community Investment Issues:
441 G Street, N.W.
Washington DC 20548:
Re: Draft Report GAO-04-889:
Dear Mr. McCool:
Thank you for the opportunity to comment on the Government
Accountability Office's draft report GAO-04-889, entitled "Financial
Regulation: Industry Changes Prompt Need to Reconsider U.S. Regulatory
Structure." The draft report discusses the current U.S. financial
regulatory structure and suggests potential alternatives. The draft
report also notes that U.S. regulators and financial market
participants generally expressed the view that the current regulatory
structure has contributed to the development of U.S. capital markets
and the overall growth and stability in the U.S. economy.
The GAO acknowledges the existence of factors, apart from structure,
that make for good and effective regulation. For example, the draft
report notes that the regulatory system benefits from the specialized
knowledge regulators acquire within their specialized agencies. In
addition, the draft report acknowledges that some regulators are
adapting their regulatory and supervisory approaches to industry
changes. The draft report includes as one example the SEC's voluntary
oversight of holding companies as Consolidated Supervised Entities.
The SEC takes the goal of good and effective regulation seriously.
[NOTE 1] We also share the conclusion in the draft report that
cooperation and coordination among financial services regulators are
important, especially in light of the consolidation of the financial
services industry and the existence of large, multifaceted, global
enterprises. Notably, however, while the financial services industry
has been changing over the past several years, Congress reaffirmed the
functional regulation of financial services conglomerates through the
enactment of the Gramm-Leach-Bliley Act of 1999.
The draft report acknowledges that there are a number of permanent
groups and regular meetings that bring together the agency heads and
staff from the financial institution regulators, as well as
international regulators. Some of these groups and regular meetings
have existed for a number of years and others have been established
since the passage of the Gramm-Leach-Bliley Act. The regular meetings
of interagency and international working groups promote communication
and the creation of working relationships among regulators at the staff
level. The existence of working relationships among staff permits the
agencies to work together more quickly and effectively both during
crisis situations and in exercising their ongoing regulatory and
supervisory functions.
Of course, supervision and regulation can always be improved, but the
costs of change must always be weighed against its benefits. As a
general matter, the U.S. financial services regulators focus their
resources on integrity, safety, soundness, investor protection, and
responding to the changing needs of the financial industry for more
flexible and constructive regulation. These efforts have resulted in
financial markets that are globally competitive and provide a broad
array of services nationally.
Thank you again for the opportunity to comment on the draft report. We
request that the GAO include a copy of this letter in the final report.
Sincerely,
Signed by:
Annette L. Nazareth:
Director:
NOTES:
[1]
For example, the SEC's Strategic Plan states:
The SEC will strengthen the integrity and soundness of U.S. securities
markets for the benefit of investors and other market participants, and
will conduct its work in a manner that is as sophisticated, flexible,
and dynamic as the securities markets it regulates.
The mission of the Securities and Exchange Commission is to protect
investors, maintain fair, orderly, and efficient markets, and
facilitate capital formation.
Securities and Exchange Commission, FY 2004-2009 Strategic Plan, July
2004.
[End of section]
Appendix VI: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Thomas J. McCool, (202) 512-8678:
James M. McDermott, (202) 512-5373:
Staff Acknowledgments:
In addition to the individuals named above, Nancy S. Barry, Emily
Chalmers, Patrick Dynes, James Kim, Marc W. Molino, Suen-Yi Meng, Kaya
Leigh Taylor, Paul Thompson, John Treanor, and Cecile Trop also made
key contributions to this report.
[End of section]
Related GAO Products:
SEC Operations: Oversight of Mutual Fund Industry Presents Management
Challenges.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-584T]
Washington, D.C.: April 20, 2004.
Securities Markets: Opportunities Exist to Enhance Investor Confidence
and Improve Listing Program Oversight.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-75]
Washington, D.C.: April 8, 2004.
Mutual Funds: Assessment of Regulatory Reforms to Improve the
Management and Sale of Mutual Funds.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-533T]
Washington, D.C.: March 10, 2004.
Government-Sponsored Enterprises: A Framework for Strengthening GSE
Governance and Oversight.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-269T]
Washington, D.C.: February 10, 2004.
Credit Unions: Financial Condition Has Improved, but Opportunities
Exist to Enhance Oversight and Share Insurance Management.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-91]
Washington, D.C.: October 27, 2003.
Critical Infrastructure Protection: Efforts of the Financial Services
Sector to Address Cyber Threats.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-03-173]
Washington, D.C.: January 30, 2003.
Potential Terrorist Attacks: Additional Actions Needed to Better
Prepare Critical Financial Market Participants.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-03-251]
Washington, D.C.: February 12, 2003.
Securities Markets: Competition and Multiple Regulators Heighten
Concerns about Self-Regulation.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-02-362]
Washington, D.C.: May 3, 2002.
SEC Operations: Increased Workload Creates Challenges.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-02-302]
Washington, D.C.: March 5, 2002.
Bank Regulation: Analysis of the Failure of Superior Bank, FSB,
Hinsdale, Illinois.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-02-419T]
Washington, D.C.: February 7, 2002.
Insurance Regulation: The NAIC Accreditation Program Can Be Improved.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-01-948]
Washington, D.C.: August 31, 2001.
Federal Reserve System: Mandated Report on Potential Conflicts of
Interest.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-01-160]
Washington, D.C.: November 13, 2000.
CFTC and SEC: Issues Related to the Shad-Johnson Jurisdictional Accord.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-89]
Washington, D.C.: April 6, 2000.
Responses to Questions Concerning Long-Term Capital Management and
Related Events.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-67R]
Washington, D.C.: February 23, 2000.
Financial Regulatory Coordination: The Role and Functioning of the
President's Working Group.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-46]
Washington, D.C.: January 21, 2000.
Long-Term Capital Management: Regulators Need to Focus Greater
Attention on Systemic Risk.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-3]
Washington, D.C.: October 29, 1999.
The Commodity Exchange Act: Issues Related to the Commodity Futures
Trading Commission's Reauthorization.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-99-74]
Washington, D.C.:
Risk-Based Capital: Regulatory and Industry Approaches to Capital and
Risk.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-98-153]
Washington, D.C.: July 20, 1998.
OTC Derivatives: Additional Oversight Could Reduce Costly Sales
Practice Disputes.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-98-5]
Washington, D.C.: October 2, 1997.
Financial Crisis Management: Four Financial Crises in the 1980s.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-96]
Washington, D.C.: May 1997.
Financial Derivatives: Actions Taken or Proposed Since May 1994.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD/AIMD-97-8]
Washington, D.C.: November 1, 1996.
Bank Oversight Structure: U.S. and Foreign Experience May Offer Lessons
for Modernizing U.S. Structure.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-23]
Washington, D.C.: November 20, 1996.
Financial Regulation: Modernization of the Financial Services
Regulatory System.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/T-GGD-95-121]
Washington, D.C.: March 15, 1995.
Financial Derivatives: Actions Needed to Protect the Financial System.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-94-133]
Washington, D.C.: May 18, 1994.
Bank Regulation: Consolidation of the Regulatory Agencies.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/T-GGD-94-106]
Washington, D.C.: March 4, 1994.
Regulatory Burden: Recent Studies, Industry Issues, and Agency
Initiatives.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-94-28]
Washington, D.C.: December 13. 1003.
[End of section]
(250151):
FOOTNOTES
[1] OTS is the supervisor for state-chartered saving associations that
belong to the Savings Association Insurance Fund.
[2] The Basel Committee, a group of central bankers and regulators from
13 countries, adopted the Basel II capital standards in June 2004.
Different countries will implement these standards at different times
and to varying degrees. In addition, regulatory agencies in the United
States that oversee different functional areas may implement these
standards differently.
[3] Futures are one type of derivatives contract. The market value of a
derivatives contract is derived from a reference rate, index, or the
value of an underlying asset, including stocks, bonds, commodities,
interest rates, foreign currency exchange rates, and indexes that
reflect the collective value of underlying financial products. The
regulation of derivatives generally varies depending on whether they
are traded on exchanges (exchange-traded) or traded over-the-counter
(OTC) and on the nature of the underlying asset, reference rate, or
index. Futures obligate the holder to buy or sell a specific amount or
value of an underlying asset, reference rate, or index at a specified
price on a specified future date and are often traded on exchanges.
Options--contracts that grant their purchasers the right but not the
obligation to buy or sell a specific amount of the underlying asset,
reference rate, or index at a particular price within a specified
period--are also sometimes traded on exchanges. See chapter 2 for more
information about derivatives.
[4] We use the term "thrifts" to refer to savings and loan associations
and the term "thrift holding companies" to refer to savings and loan
holding companies throughout this report.
[5] Our report Credit Unions: Financial Condition Has Improved, but
Opportunities Exist to Enhance Oversight and Share Insurance
Management, GAO-04-91 (Washington, D.C.: Oct. 27, 2003) discusses the
credit union industry and the National Credit Union Administration
(NCUA). Because credit unions have only about 9 percent of domestic
deposits, this report does not discuss them in detail.
[6] ILCs are state-chartered institutions that may take deposits and
offer some banking services, but generally are not permitted to offer a
full range of bank services. GAO has an ongoing engagement looking at
certain issues related to ILCs. Because ILC's have only about 1 percent
of domestic deposits, this report does not discuss them in detail.
[7] For example, associated persons who may act on behalf of other
futures firms also play a role in futures markets.
[8] We recognize that there are alternative ways to categorize risks.
[9] We use the term Federal Reserve throughout this report to refer to
the Federal Reserve's Board of Governors, the 12 Federal Reserve Banks,
or both, unless otherwise specified.
[10] See Financial Institution Reform, Recovery and Enforcement Act of
1989 (FIRREA) § 407, 103 Stat. 363.
[11] NASD is registered as a national securities association under
section 15A of the Securities Exchange Act of 1934, 15 U.S.C. § 78o-3,
(2000 & Supp. 2004) and is considered an SRO pursuant to section
3(a)(26), 15 U.S.C. & 78c(a)(26).
[12] These SROs include those dealing in exchange-traded options. SEC
shares oversight of exchange-traded options with CFTC depending on the
nature of the underlying.
[13] SEC regulates sales of discrete products, such as certain types of
annuities considered to be securities. Also, banks engage in certain
types of insurance activities, such as underwriting credit insurance
and, under certain circumstances, acting as an insurance agent either
directly or through a subsidiary. Although these activities are subject
to OCC regulation, national banks can be subject to nondiscriminatory
state laws applicable to certain insurance-related activities.
[14] The Bank Holding Company Act exempts certain types of depository
institutions, such as ILCs chartered in certain states, from its
definition of "bank," as well as some grandfathered banks.
Consequently, a company's ownership or control of an ILC does not
necessarily subject the company to supervision by the Federal Reserve.
[15] The "functionally regulated" affiliates (and their respective
functional regulators) are: registered broker-dealers, investment
advisers, and investment companies (SEC); state-regulated insurance
companies (state insurance authority); and CFTC-regulated firms (CFTC).
[16] Before the enactment of GLBA, a unitary thrift holding company
whose subsidiary thrift was a qualified thrift lender generally could
operate without activity restrictions. Additionally, a multiple thrift
holding company that acquired all, or all but one, of its subsidiary
thrifts as a result of supervisory acquisitions generally could operate
without activity restrictions if all of the subsidiary thrifts were
qualified thrift lenders. These thrift holding companies have been
referred to as "exempt." The majority of thrift holding companies
qualify as exempt. Nonexempt thrift holding companies were permitted to
engage only in those nonbanking activities that were: specified by the
Home Owners' Loan Act; approved by regulation as closely related to
banking by the Federal Reserve; or authorized by regulation on March 5,
1987.
[17] Pub. L. No. 101-432§ 4(a), 15 U.S.C. § 78q(h) (providing for,
among other things, SEC risk assessment of holding company systems).
[18] For the SEC rules regarding consolidated supervised entities, see
69 Fed. Reg. 34428 (June 21, 2004). For the SEC rules regarding
supervised investment bank holding companies, see 69 Fed. Reg. 34472
(June 21, 2004).
[19] See GAO, Federal Reserve System: Mandated Report on Potential
Conflicts of Interest, GAO-01-160 (Washington, D.C.: Nov. 13, 2000).
[20] The Federal Reserve is represented by principals from the Federal
Reserve Board of Governors and the Federal Reserve Bank of New York.
OTS officials say that they participate in the Basel Committee as a
temporary member pending acceptance of OTS's request for permanent
membership.
[21] The committee's members come from Belgium, Canada, France,
Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden,
Switzerland, the United Kingdom, and the United States.
[22] The Joint Forum was initially referred to as "The Joint Forum on
Financial Conglomerates." During 1999, its name was shortened to "The
Joint Forum" to recognize that its new mandate went beyond issues
related to financial conglomerates to other issues of common interest
to all three sectors.
[23] The countries are Australia, Belgium, Canada, France, Germany,
Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the United
Kingdom, and the United States.
[24] We recently reviewed our work on regulation of government-
sponsored enterprises in Government-Sponsored Enterprises: A Framework
for Strengthening GSE Governance and Oversight, GAO-04-269T
(Washington, D.C.: Feb. 10, 2004).
[25] See GAO-04-91.
[26] Pub. L. No. 103-328, 108 Stat. 2238 (1994).
[27] Gianni De Nicoló, Philip Bartholomew, Jahanara Zaman, and Mary
Zephirin, "Bank Consolidation, Internationalization, and
Conglomeration: Trends and Implications for Financial Risk" (IMF
Working Paper 03/158, Washington, D.C., July 2003).
[28] Mortgage-backed securities numbers are from the Federal Reserve's
flow of funds data and include federal agency and government sponsored
enterprise-backed mortgage pools and mortgages backing privately issued
pool securities and collateralized mortgage obligations.
[29] See chapter 4 for information about capital requirements.
[30] For earlier information on derivatives, see GAO, Financial
Derivatives: Actions Needed to Protect the Financial System, GAO/GGD-
94-133 (Washington, D.C.: May 18, 1994); and Financial Derivatives:
Actions Taken or Proposed Since May 1994, GAO/GGD/AIMD-97-8
(Washington, D.C.: Nov. 1, 1996).
[31] IMF, Global Financial Stability Report: Market Developments and
Issues, April 2004 (Washington, D.C., April 2004).
[32] See IMF, Global Financial Stability Report, April 2004; FSA,
Cross-Sector Risk Transfers (London, U.K., May 2002); and Committee on
the Global Financial System of the Bank for International Settlements,
Global Credit Risk Transfer (Basel, Switzerland, January 2003).
[33] GAO, Long-Term Capital Management: Regulators Need to Focus
Greater Attention on Systemic Risk, GAO/GGD-00-3 (Washington, D.C.:
Oct. 29, 1999).
[34] Bank for International Settlements, 69th Annual Report, 1 April
1998-31 March 1999 (Basel, Switzerland; June 7, 1999).
[35] Richard Herring and Til Schuermann, "Capital Regulation for
Position Risk in Banks, Securities Firms, and Insurance Companies"
(paper at the Conference on Risk-Based Capital: The Tensions between
Regulatory and Market Standards, Program on International Financial
Systems, Harvard Law School (Cambridge, Massachusetts; June 10, 2003).
[36] The failure of Barings did not involve the use of British
government funds. In addition, officials at the Federal Reserve note
that Barings was much smaller than many of today's banking
organizations.
[37] José de Luna Martínez and Thomas A. Rose, "International Survey of
Integrated Financial Sector Supervision" (World Bank Policy Research
Working Paper 3096, July 2003).
[38] The EU is a treaty-based organization of European countries in
which those countries cede some of their sovereignty so that decisions
on specific matters of joint interest can be made democratically at the
European level.
[39] Together with the state central banks, the European Central Bank
conducts monetary policy for the EU, but has no regulatory or
supervisory powers.
[40] Officials in the Netherlands call this functional regulation as do
officials in other countries that have adopted a similar structure.
[41] Regarding exchange-traded futures, federal law generally pre-empts
state authority. However, states may have jurisdiction to enforce anti-
fraud laws related to activities involving futures contracts.
[42] See Federal Reserve Board, Order Approving Formation of a Bank
Holding Company and Notice to Engage in Nonbanking Activities, 84 Fed.
Res. Bull. 985 (1998).
[43] Under OCC regulations effective December 31, 1996, national banks
were permitted to engage in a broader range of activities through
subsidiaries than the Comptroller permitted within the banks
themselves. See 61 Fed. Reg. 60351-52 (Nov. 27, 1996).
[44] National banks can be subject to SEC broker registration
requirements if they execute orders for customers that involve
securities not exempt from SEC jurisdiction or transactions not subject
to an exception under the securities laws. See 15 U.S.C. § 78c(a)(4)
(2000 & Supp. 2004).
[45] Subject to the preemption standard set forth in GLBA and
prohibitions against discriminatory state laws, GLBA authorizes limited
state regulation of insurance sales by banks and savings associations.
Pub. L. No. 106-102 § 104, 15 U.S.C. § 6701 (2000 & Supp. 2004).
[46] Pub. L. No. 106-102 § 307, 15 U.S.C. § 6716 (2000 & Supp. 2004).
[47] Pub. L. No. 106-102 §§ 111, 112, 12 U.S.C. §§ 1844(c), (g).
[48] Pub. L. No. 106-102 § 111, 12 U.S.C. § 1844(c).
[49] Pub. L. No. 106-102 § 321.
[50] This proposal was outlined in the statement of the Honorable Lloyd
Bentsen, Secretary of the Treasury, before the Committee on Banking,
Housing, and Urban Affairs of the U.S. Senate (Mar. 1, 1994).
[51] H.R. 1227: The Bank Regulatory Consolidation and Reform Act of
1993 (Mar. 4, 1993).
[52] CRS, Bank Regulatory Agency Consolidation Proposals: A Structural
Analysis (Washington, D.C; Mar. 18, 1994).
[53] This proposal was outlined in the statement of Alan Greenspan,
Chairman, Board of Governors of the Federal Reserve System, before the
Committee on Banking, Housing, and Urban Affairs of the U.S. Senate
(Mar. 2, 1994).
[54] SIA, Reinventing Self-Regulation, White Paper of the Securities
Industry Association's Ad Hoc Committee on Regulatory Implications of
De-Mutualization (Washington, D.C; Jan. 5, 2000). We discussed this
report and SEC's views in our report Securities Markets: Competition
and Multiple Regulators Heighten Concerns about Self-Regulation, GAO-
02-362 (Washington, D.C.: May 3. 2002).
[55] GAO-02-362.
[56] In 1965, SEC became responsible for direct regulation of a small
number of broker-dealers that traded only in the over-the-counter
market. This program, called the Securities and Exchange Only program,
was designed to provide participating firms with a regulatory
alternative to NASD. In 1983, SEC concluded that the industry would be
better served if the program were discontinued, because needed
improvements would be costly and not an efficient use of agency
resources.
[57] The Basel II framework includes several levels of approaches for
determining capital requirements for banks. While the standard
approaches will be available for implementation in 2006, the most
advanced approaches, which are the only ones being proposed for some
U.S. banks, will not be available for implementation until 2007.
[58] Off-balance sheet items are financial contracts that can create
credit losses for banks but are not reported on banks' balance sheets
under standard accounting practices. An example of such an off-balance
sheet position is a letter of credit or an unused line of credit
committing the bank to making a loan in the future that would be on the
balance sheet and thus creates a credit risk. To adjust for credit
risks created by financial positions not reported on the balance sheet,
U.S. regulations provide conversion factors to express off-balance
sheet items as equivalent on-balance sheet items, as well as rules for
incorporating the credit risk of off-balance sheet derivatives.
[59] EU member states have been required to adopt capital adequacy
rules that are generally consistent with Basel standards for credit
institutions (banks and securities firms). Thus, to satisfy the EU
requirements, U.S. banks and securities firms operating in EU member
states would be subject to similar requirements. The EU is currently
considering amendments to relevant directives partly in response to the
adoption of Basel II.
[60] See SEC, Alternative Net Capital Requirements for Broker-Dealers
That Are Part of Consolidated Entities, 69 FR 34428 (June 21, 2004);
and Supervised Investment Bank Holding Companies 69 FR 34472 (June 21,
2004).
[61] Because the EU Financial Conglomerate Directive is effective in
January 2005 and the Basel II standards are not required until year-end
2006, there is some question as to whether CSEs will adopt Basel II
standards at the time of their registration.
[62] Some bank, financial, and thrift holding companies with
significant broker-dealer affiliates may also register as CSEs. Their
broker-dealers will have the option of complying with the capital
standards consistent with Basel II rather than SEC's net capital rule.
[63] SEC staff notes that it raised this issue before completion of the
final Basel II draft.
[64] GAO, Risk-Focused Bank Examinations: Regulators of Large Banking
Organizations Face Challenges, GAO/GGD-00-48 (Washington, D.C.: Jan.
24, 2000).
[65] See joint press release issued by Federal Reserve, FDIC, NCUA,
OCC, and OTS (Washington, D.C; July 28, 2004), http://
www.federalreserve.gov/boarddocs/press/bcreg/2004/20040728/
default.htm (downloaded Sept. 10, 2004). See also 31 U.S.C. 5318(l)
(2000 & Supp. 2004).
[66] GAO, SEC Operations: Increased Workload Creates Challenges, GAO-
02-302 (Washington, D.C.: Mar. 5, 2002).
[67] GAO, SEC Operations: Oversight of Mutual Fund Industry Presents
Management Challenges, GAO-04-584T (Washington, D.C.: Apr. 20, 2004).
[68] GAO-04-584T, 14.
[69] See 7 U.S.C. § 7a(d) (2000 & Supp. 2004).
[70] See Trading Facilities, Intermediaries and Clearing Organizations;
New Regulatory Framework; Final Rule, 66 Fed. Reg. 42256-42289 (Aug.
10, 2001); see also Proposed Rules for Execution of Transactions:
Regulation 1.38 and Guidance on Core Principle 9 69 Fed. Reg. 39880-
39886 (July 1, 2004).
[71] 17 C.F.R. § 37.6 (2004).
[72] Pub. Law No. 95-630, Title X. See http://www.ffiec.gov/about.htm.
[73] Offices of the Inspector General at Treasury, FDIC, and Federal
Reserve, Joint Evaluation of the Federal Financial Institutions
Examination Council (Washington, D.C; June 21, 2002).
[74] See OCC, "Policy Statement on Examination Coordination and
Implementation Guidelines," Examination Planning and Control Handbook
(Washington, D.C., July 1997).
[75] OTS officials say that they participate in the Basel Committee as
a temporary member pending acceptance of OTS's request for permanent
membership.
[76] See GAO, Bank Regulation: Analysis of the Failure of Superior
Bank, FSB, Hinsdale, Illinois, GAO-02-419T (Washington, D.C.: Feb. 7,
2002).
[77] Letter from Representative Michael Oxley et al. to Chairman Alan
Greenspan et al., Nov. 3, 2003.
[78] GAO, Securities Markets: Competition and Multiple Regulators
Heighten Concerns about Self-Regulation, GAO-02-362 (Washington, D.C.:
May 3, 2002).
[79] GAO, Insurance Regulation: The NAIC Accreditation Program Can Be
Improved, GAO-01-948 (Washington, D.C.: Aug. 31, 2001).
[80] GAO, Financial Regulatory Coordination: The Role and Functioning
of the President's Working Group, GAO/GGD-00-46 (Washington, D.C.: Jan.
21, 2000).
[81] GAO, Critical Infrastructure Protection: Efforts of the Financial
Services Sector to Address Cyber Threats, GAO-03-173 (Washington, D.C.:
Jan. 30, 2003).
[82] The commission was created in Title V of the Fair and Accurate
Credit Transactions Act of 2003, known as the Financial Literacy and
Education Improvement Act. See Pub. L. No. 108-159, Title V, 117 Stat.
2003 (codified at 20 U.S.C. §§ 9701-08). The act also mandated that GAO
report on recommendations for improving financial literacy among
consumers. On July 28, 2004, GAO hosted a forum entitled "Improving
Financial Literacy: The Role of the Federal Government." The results of
this forum will appear in a forthcoming GAO report.
[83] GAO/GGD-00-46.
[84] GAO, Long-Term Capital Management: Regulators Need to Focus
Greater Attention on Systemic Risk, GAO/GGD-00-3 (Washington, D.C.:
Oct. 29, 1999).
[85] GAO, Financial Crisis Management: Four Financial Crises in the
1980s, GAO/GGD-97-96 (Washington D.C.: May 1, 1997).
[86] GAO, Potential Terrorist Attacks: Additional Actions Needed to
Better Prepare Critical Financial Market Participants, GAO-03-251
(Washington, D.C.: Feb. 12, 2003).
[87] GAO, Better Information Sharing among Financial Services
Regulators Could Improve Protections for Consumers, GAO-04-
882R (Washington, D.C.: June 29, 2004).
[88] See GAO/GGD-00-3; and GAO, Responses to Questions Concerning Long-
Term Capital Management and Related Events, GAO/GGD-00-67R (Washington,
D.C.: Feb. 23, 2000).
[89] See GAO-03-251.
[90] Gianni De Nicoló, Philip Bartholomew, Jahanara Zaman, and Mary
Zephirin, "Bank Consolidation, Internationalization, and
Conglomeration: Trends and Implications for Financial Risk" (IMF
Working Paper 03/158, Washington, D.C., July 2003).
[91] See GAO, Telecommunications: Better Coordination and Enhanced
Accountability Needed to Improve Spectrum Management, GAO-02-906
(Washington, D.C.: Sept. 30, 2002).
[92] GAO/GGD-00-3, 3.
[93] Statement of Ellen Seidman, Director of the Office of Thrift
Supervision, in U.S. Senate, Committee on Banking, Finance, and Urban
Affairs, "The Failure of Superior Bank, FSB, Hinsdale, Illinois,"
September 11, 2001, and October 16, 2001, S. Hrg. 107-698, p. 13.
[94] Office of the Inspector General, FDIC, Issues Related to the
Failure of Superior Bank, FSB, Hinsdale, Illinois, Audit Report 02-005
(Washington, D.C; Feb. 6, 2002); and GAO, Bank Regulation: Analysis of
the Failure of Superior Bank, FSB, Hinsdale, Illinois, GAO-02-419T
(Washington, D.C.: Feb. 7, 2002).
GAO's Mission:
The Government Accountability Office, the investigative arm of
Congress, exists to support Congress in meeting its constitutional
responsibilities and to help improve the performance and accountability
of the federal government for the American people. GAO examines the use
of public funds; evaluates federal programs and policies; and provides
analyses, recommendations, and other assistance to help Congress make
informed oversight, policy, and funding decisions. GAO's commitment to
good government is reflected in its core values of accountability,
integrity, and reliability.
Obtaining Copies of GAO Reports and Testimony:
The fastest and easiest way to obtain copies of GAO documents at no
cost is through the Internet. GAO's Web site ( www.gao.gov ) contains
abstracts and full-text files of current reports and testimony and an
expanding archive of older products. The Web site features a search
engine to help you locate documents using key words and phrases. You
can print these documents in their entirety, including charts and other
graphics.
Each day, GAO issues a list of newly released reports, testimony, and
correspondence. GAO posts this list, known as "Today's Reports," on its
Web site daily. The list contains links to the full-text document
files. To have GAO e-mail this list to you every afternoon, go to
www.gao.gov and select "Subscribe to e-mail alerts" under the "Order
GAO Products" heading.
Order by Mail or Phone:
The first copy of each printed report is free. Additional copies are $2
each. A check or money order should be made out to the Superintendent
of Documents. GAO also accepts VISA and Mastercard. Orders for 100 or
more copies mailed to a single address are discounted 25 percent.
Orders should be sent to:
U.S. Government Accountability Office
441 G Street NW, Room LM
Washington, D.C. 20548:
To order by Phone:
Voice: (202) 512-6000:
TDD: (202) 512-2537:
Fax: (202) 512-6061:
To Report Fraud, Waste, and Abuse in Federal Programs:
Contact:
Web site: www.gao.gov/fraudnet/fraudnet.htm
E-mail: fraudnet@gao.gov
Automated answering system: (800) 424-5454 or (202) 512-7470:
Public Affairs:
Jeff Nelligan, managing director,
NelliganJ@gao.gov
(202) 512-4800
U.S. Government Accountability Office,
441 G Street NW, Room 7149
Washington, D.C. 20548: